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Full text of "Federal income tax aspects of mergers and acquisitions : scheduled for hearings before the Subcommittee on Oversight and the Subcommittee on Select Revenue Measures of the Committee on Ways and Means on April 1, 2, and 16, 1985"

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Scheduled for Hearings 






ON APRIL 1, 2, AND 16, 1985 

Prepared by the Staff 



MARCH 29, 1985 

45-411 O WASHINGTON : 1985 


Introduction 1 

I. Overview 2 

II. Tax Policy and the Market for Corporate Control .... 4 

A. Summary of Tax Rules 4 

1. General provisions of the corporate income 

tax.. 4 

2. General provisions of the individual income 

tax 5 

3. General provisions of the estate and gift tax ... 6 

4. Income tax treatment of acquisitions 6 

B. Effect of Tax Rules on Merger Activity 8 

1. Distributive mergers 8 

2. Churning mergers 10 

3. Leveraged mergers 11 

4. Tax benefit transfer mergers 12 

5. Other tax-motivated mergers 12 

6. Tax barriers to mergers 12 

C. Policy Implications of Tax-Motivated Merger Ac- 

tivity 13 

D. Proposals for Change 14 

III. The Acquisition Transaction Simplified: The Federal 

Income Tax Perspective 17 

IV. Present Law Rules 25 

A. Forms of Acquisition 25 

1. Taxable acquisitions 25 

a. Asset acqusitions 25 

b. Stock acquisitions 29 

2. Tax-free reorganizations 35 

a. Asset reorganizations 35 

b. Stock reorganizations 37 

c. Bankruptcy reorganizations 37 

d. Treatment of parties to a reorganization .. 37 

B. Financing Aspects of Acquisitions 40 

1. In general 40 

a. Equity financing 40 

b. Debt financing 41 




2. Specific provisions affecting debt-financed ac- 
quisitions 42 

a. Cost recovery allowances and installment 

reporting 42 

b. Provisions relating to qualified pension 

plans 43 

c. Provisions relating to international tax- 

ation 47 

d. Provisions relating to partnerships 48 

C. Golden Parachutes 48 

V. Possible Changes in the Tax Rules Applicable to 

Mergers and Acquisitions 50 

Appendix: Additional Possible Changes of a Technical Char- 
acter Relating to the Taxation of Corporations and Their 
Shareholders 55 


The Subcommittee on Oversight of the Committee on Ways and 
Means, in conjunction with the Subcommittee on Select Revenue 
Measures, has scheduled hearings on April 1, 2, and 16, 1985, on 
Federal income tax aspects of corporate mergers and acquisitions. 
This pamphlet,* prepared in connection with the hearings, provides 
a description of many of the relevant Federal income tax consider- 

The first part of the pamphlet contains an overview. The second 
part generally discusses tax policy issues raised by the applicable 
and proposed tax rules. Part three describes, in simplified form, 
common forms of acquisition transactions, and part four contains a 
more detailed and technical articulation of the applicable tax rules. 
The fifth part discusses possible changes in some of those rules and 
suggests other areas that may warrant further examination. An 
Appendix briefly describes possible technical amendments that 
might be considered. 

*This pamphlet may be cited as follows: Joint Committee on Taxation, Federal Income Tax 
Aspects of Mergers and Acquisitions (JCS-6-85), March 29, 1985. 



The United States is presently in the midst of what appears to be 
the fourth major merger^ wave since the turn of the century (see 
Table 1). Like the current merger wave, previous merger booms oc- 
curred during strong stock market upswings. ^ Merger waves are 
thought to be related to a variety of economic factors including 
stock market fluctuations, advances in production and distribution 
technology, and changing demand conditions. In addition, merger 
activity is indirectly influenced by the tax system and is directly 
regulated by the Federal Trade Commission, the Justice Depart- 
ment, the Securities and Exchange Commission, and other agen- 

Table 1. — Mergers and Acquisitions, 1968-84 

[Dollar amounts in billions] 


Number of 
tions ^ 

Value of consideration 
exchanged ^ 


(1983) dollars 

1968 4,462 

1969 6,107 

1970 5,152 

1971 4,608 

1972 4,801 

1973 4,040 

1974 2,861 

1975 2,297 

1976 2,276 

1977 2,224 

1978 2,106 

1979 2,128 

1980... 1,889 

1981 2,395 

1982 2,346 



' Under the Internal Revenue Code, "merger" is a term of art, referring to certain kinds of 
combinations of one corporation with another on a tax-free basis under section 368(a)(1)(A). In 
this pamphlet, the term generally (except in part four) is used in a non-technical sense to refer 
to any acquisition of one corporation by another. 

^ F. M. Scherer, Industrial Market Structure and Economic Performance, 1970. Scherer identi- 
fies 3 merger waves up to 1970: 1887-1904, 1916-1929, and the post-World War II recovery 
through 1970. 


Table 1.— Mergers and Acquisitions, 1968-84— Continued 

[Dollar amounts in billions] 

Year transac- 

Value of consideration 
Number of exchanged ^ 

tions 1 Nominal Constant 

dollars (1983) dollars 

1983 2,533 73.1 73.1 

1984 2,543 122.2 117.8 

1 Includes only publicly-announced transactions involving transfers of ownership 
of 10 percent or more of a company's assets or equity, provided that the value of 
the transaction is at least $500,000. 

2 Includes only those transactions for which valuation data are publicly reported. 
Sources: W.T. Grimm & Company and Council of Economic Advisors. 

The current upsurge of merger activity has received considerable 
publicity because of the unprecedented size of the corporations that 
have been acquired and the costly and novel defensive and offen- 
sive strategies that have been pursued in huge takeover contests. 
Some have expressed concern that the $122 billion spent on merg- 
ers and acquisitions last year diverted corporate resources and 
management attention away from more productive internal invest- 
ment opportunities and management responsibilities. Others con- 
tend that the threat and conduct of takeovers is socially beneficial 
because management is forced to maximize the value of corporate 
assets or risk losing operating control. The effect of tax and regula- 
tory policies on the market for corporate control is an issue of sig- 
nificant economic and political consequence: the market value of 
the securities issued by publicly-traded corporations accounts for 
over 20 percent of the nation's wealth. ^ 

Certain features of the corporate and individual income tax (as 
well as of the estate and gift tax) may affect the attractiveness of 
mergers from the standpoint of both the acquiring and target cor- 
porations and their shareholders. The tax Code may be harmful to 
economic growth if tax considerations encourage inefficient, or dis- 
courage efficient, changes in the ownership of corporations or their 

3 Annual Report of the Council of Economic Advisers (February 1985). 



The tax Code influences corporate acquisitions directly through 
rules governing the sale or other disposition of corporate stock or 
assets and indirectly through the general rules pertaining to the 
taxation of corporate and individual income and of estates. The 
interaction of these tax rules may affect the number of acquisi- 
tions, the form of an acquisition, the type and amount of consider- 
ation paid, the tactics used in takeover contests, and the corpora- 
tions that are candidates for becoming acquirors or targets. The or- 
ganization of this part is as follows: first, the relevant tax rules are 
summarized; s3cond, the effect of those rules on the form and sub- 
stance of merger activity is analyzed; third, the policy implications 
of tax-motivated merger activity are assessed; and fourth, some 
general proposals for change are evaluated. 

A. Summary of Tax Rules 

Three features of the Federal income tax appear to have the 
most significant effect on the pattern of merger activity: (1) the dif- 
fering tax consequences of acquiring an entire corporation versus 
acquiring individual corporate assets; (2) the disparate treatment of 
various forms of corporate "distributions" resulting made in the 
form of interest, dividends, and long-term capital gains; and (3) the 
inability of corporations with limited taxable income to take full 
advantage of business tax preferences. These and other aspects of 
the tax rules are described below. 

1. General provisions of the corporate income tax 

Income from corporate assets that is paid to debtholders is not 
subject to tax at the corporate borrower level since interest pay- 
ments generally are deductible for purposes of computing taxable 
income. Conversely, corporate income paid out as dividends is sub- 
ject to corporate level tax since dividend payments are not deducti- 
ble by a corporation. Thus, the combined individual and corporate 
tax on debt-financed investment is no more than 50 percent (the 
top individual rate), while the combined tax on income distributed 
from equity-financed investment is as high as 73 percent (assuming 
a 46-percent corporate rate).** As a result, the after-tax return on a 
dollar of income on debt-financed assets (50 cents) is, at the highest 
tax rates, almost double the return on a dollar from equity-fi- 
nanced investment (27 cents). A company with a high debt-to- 
equity ratio may have a tax advantage over a similar company 
with little debt financing. Debt-financed acquisitions effectively in- 

* In this case, $100 of corporate income is subject to $46 of corporate income tax, and the 
remaining $54 of after-tax corporate income is subject to up to $27 of tax at the shareholder 
level when distributed. The maximum combined tax is $73 ($46 plus $27). 


crease the debt-to-equity ratio of the acquired corporation and thus 
may increase share price to the extent that the tax advantages of 
debt financing are not outweighed by the disadvantages (e.g., in- 
creased bankruptcy risk). 

Under current law, a substantial percentage of the economic 
income of corporations escapes corporate income tax as a result of 
various tax preferences provided by the Code. Examples of these 
preferences include the investment tax credit and accelerated de- 
preciation. These preferences cannot be used on a current basis by 
corporations that do not have sufficient taxable income in the cur- 
rent or prior 3 years. Such corporations can carry forward (up to 15 
years) net operating losses and excess credits until current taxable 
income is sufficient to absorb them.^ Companies in a carryforward 
position are often at a tax disadvantage relative to companies that 
have sufficient taxable income to use available tax preferences cur- 
rently.^ Thus, there is a tax incentive for structuring mergers 
which effectively permit more rapid utilization of current prefer- 
ences and carryforwards.^ 

2. General provisions of the individual income tax 

Shareholders are taxed on the income from corporate assets only 
when distributed as a dividend or when gain is realized from a sale 
or other disposition of their shares. Thus, shareholders can defer 
tax on corporate income that is reinvested rather than distributed 
as a dividend. This may result in large accumulations of undistrib- 
uted corporate income and attract takeover attempts.® If reinvest- 
ment opportunities are limited, management may decide to use re- 
tained income to acquire control of another corporation, lest their 
own corporation be subject to a similar fate. Alternatively, retained 
earnings might be used by the corporation to redeem, or repur- 
chase, its own shares; however, management may prefer to expand 
the size of the corporation through acquisition rather than shrink 
it through redemptions of shares. 

Individual shareholders are taxed at ordinary income rates, of up 
to 50 percent, on dividends paid out of corporate earnings. Howev- 
er, individuals are taxed on only 40 percent of capital gains from 
the sale or other disposition of stock (as a result of the 60 percent 
capital gain deduction). Consequently, the effective rate of tax on 
capital gains of individuals is no more than 20 percent. Further, be- 
cause of the stepup in basis of property at death, some gain is not 
taxed at all. Thus, the Code creates an incentive for corporate 
transactions and financial policies that produce capital gains, 
whether currently taxable or deferred, rather than dividends for 
individual shareholders. 

^ A corporation experiencing a real economic loss might have NOL and foreign tax credit car- 
ryovers even in the absence of tax preferences. However, the prevalence of corporate tax prefer- 
ences greatly increases the likelihood that even a profitable corporation will be in a carr3^or- 
ward position. 

^ Corporations may seek to absorb their NOLs by the sale and leaseback of their assets, by 
recognizing built-in gains, or by other transactions. However, these transactions may be costly 
or unavailable. 

" Use of NOLs, excess credits, and built-in losses following an acquisition is limited by Code 
sections 382, 383, and 269, among others, and by the consolidated return regulations. 

* Section 531 (relating to unreasonable accumulations) and other sections seek to limit the 
accumulation of corporate earnings. 

3. General provisions of the estate and gift tax 

Federal estate tax generally applies to the transfer of property at 
death. In general, the estate tax applies equally to transfers of 
shares in closely- and widely-held corporations, although, in prac- 
tice, there are differences. First, the valuation of shares in a close- 
ly-held corporation is less certain, so that the amount of estate tax 
that will be assessed by the Internal Revenue Service is more diffi- 
cult to predict. Second, shares in closely-held corporations are less 
liquid. This may make it difficult for the executors to dispose of 
stock in order to pay estate taxes and other expenses. These consid- 
erations may lead a shareholder in a small corporation to exchange 
his shares, in a tax-free reorganization, for shares in a publicly- 
traded corporation. However, the Code does contain a number of 
provisions which mitigate the estate-tax disadvantages of holding 
shares in closely-held corporations and, as a consequence, reduce 
the incentive to merge solely for estate tax purposes.^ 

4. Income tax treatment of acquisitions 

The Code distinguishes among the taxable purchase of corporate 
stock, the taxable purchase of corporate assets, and tax-free reorga- 
nizations for income tax purposes (see Table 2). The applicable tax 
rules have been criticized on the grounds that economically similar 
acquisition transactions have different Federal tax consequences 
depending on their legal form. 

Control of a corporation's assets can be obtained either by acquir- 
ing the assets of the target corporation or by acquiring its stock 
from the target's shareholders. Generally, the sale of assets by a 
corporation in a taxable transaction results in the recognition of 
gain (or loss) to the seller. In addition, the buyer uses its cost for 
the assets for the purpose of subsequent depreciation, depletion, 
and amortization deductions and gain or loss computations. 

On the other hand, the purchase of a corporation's assets and its 
subsequent liquidation pursuant to a plan of complete liquidation 
under section 337 generally does not trigger corporate recognition 
of gain (although there are exceptions for recapture and similar 
items) or loss.^° Even though gain is not generally recognized, the 
purchaser will step-up the basis of the assets to their cost. A simi- 
lar result is obtained by a purchase of shares followed by a section 
338 election. If there is such an election, the target generally is 
treated as having sold its assets in a section 337 transaction. 

Alternatively, the purchase of the stock of a corporation may 
avoid gain recognition (including recapture) by that corporation if a 
"carryover" transaction is chosen. In a carryover transaction, the 
acquired corporation retains its tax attributes (such as net operat- 
ing loss carryovers, credit carryovers and asset basis). Corporate- 

^ Section 6161(a)(2) provides for an extension in the payment of estate tax under certain condi- 
tions. See also section 6166. Section 303 provides exchange rather than dividend treatment for 
redemptions of certain stock included in an estate in an amount up to the amount of estate 
taxes and administrative expenses. In addition, the Economic Recovery Tax Act of 1981 liberal- 
ized the estate and gift tax. See Alan L. Feld, Tax Policy and Corporate Concentration (1982), pp. 

'" Section 337 is an extension of the "codification" of General Utilities and Operating Co. v. 
Helvering, 296 U.S. 200 (1935), in section 336. General Utilities is often cited for the proposition 
that, absent a Code section to the contrary, a corporation recognizes no gain or loss when prop- 
erty is distributed to shareholders. 

level carryover tax treatment is accorded in tax-free reorganiza- 
tions and in taxable stock acquisitions where a section 338 election 
is not made or deemed made. Determining whether carryover or 
step-up tax treatment is more favorable requires considerable anal- 
ysis, and the acquirer in a taxable stock acquisition frequently will 
take advantage of the time allowed by section 338(g)(1) before 
making a section 338 election. ^^ 

Table 2. — Income Tax Treatment of Corporate Acquisitions 






Tax consequence 


tion with 

sec. 338 
election ^ 

without sec. 
338 election 


Corporate income 


Recognition of 







... Yes 




Revaluation of 






Transfer of 




Yes. 3 

NOLs2 . 

Individual income 


Recognition of 

gain /loss on 

exchange of 

shares for: 

1. Cash. 

... N.A. 




2. Debt 

... N.A. 




3. Stock 

... N.A. 




^ The same tax results generally flow from a liquidating sale under section 337. 
^ Similar tax treatment applies to credit carryovers and built-in losses. 
^ Use of NOL and credit carryovers and built-in losses is limited by sections 382, 
383, and 269, among others, and by the consolidated return rules. 

The tax consequences of a corporate acquisition at the sharehold- 
er level hinge on whether the acquisition is structured as a tax-free 
reorganization and on the type of consideration received. In quali- 
fied reorganizations, shareholders of the target corporation are not 
taxed currently if they exchange their stock or securities solely for 
stock or securities in the acquiring corporation. ^^ By contrast, in 

' ' Under Treas. temp. regs. sec. 5f.338-l(c), a section 338 election need not be made before 60 
days after publication of the next set of temporary regulations under section 338. 

' ^ The Code provides rules governing 6 generic types of corporate reorganizations which qual- 
ify for tax-free treatment: (A) statutory mergers; (B) acquisitions of stock for stock; (C) acquisi- 
tions of property for stock; (D) transfer of assets to controlled corporations; (E) recapitalizations; 


taxable stock acquisitions and liquidating sale transactions, share- 
holders of the target corporation are generally taxed currently 
even if they receive stock in exchange for their shares (as if their 
shares had been sold). 

Under the installment sale rules, where target corporation share- 
holders exchange their shares for non-readily tradable term debt of 
the acquiring company in a tax-free reorganization, taxable stock 
acquisition, or liquidating sale transaction, the recognition of gain 
generally may be deferred until principal payments on the note are 
received, (sec. 453). If the acquiring corporation makes a section 338 
election in a taxable stock acquisition, then basis in the acquired 
assets is revalued at the date of election taking into account on the 
principal amount of the note, even though the target's sharehold- 
ers recognize gain only as principle is amortized. In this manner, 
the buyer can step up basis while the target corporation wholly es- 
capes tax on gain and its shareholders defer tax on gain. 

In summary, the tax treatment of economically similar acquisi- 
tion transactions depends on the legal form of the transaction. 
Rather than sell its appreciated property, or distribute its assets re- 
tained earnings directly to shareholders, a corporation may achieve 
more favorable tax results in a properly structured acquisition. 
Thus, the decision to execute a corporate acquisition, and the deci- 
sion to structure the acquisition in a particular legal form, are both 
influenced by tax considerations. 

B. Effect of Tax Rules on Merger Activity 

Although mergers are often motivated by factors other than tax, 
Federal tax rules do create a number of opportunities for using 
mergers as tax planning devices. In this section, four tax planning 
strategies involving the use of mergers are identified: (1) merger as 
a means of distributing corporate assets ("distributive" merger): (2) 
merger as a means of churning the tax benefits on depreciable 
assets ("churning" merger); (3) merger as a means of increasing 
debt financing ("leveraged" merger); and (4) merger as a means of 
transferring tax benefits ("tax benefit transfer" merger). In addi- 
tion, tax barriers to merger (i.e., situations where the tax rules 
may inhibit merger) are also discussed. 

1. Distributive mergers 

The Federal income tax rules generally conform to the principle 
that earnings and gain are taxed both at the corporate level and 
the shareholder level to the extent received or accrued. However, 
in certain types of mergers and acquisitions, it is possible to struc- 
ture transactions so as to escape, defer, or reduce the rate of tax- 
ation at both the corporate and shareholder levels. 

The consequences of the tax rules can be illustrated by means of 
two simplified examples involving a corporation with $100 of re- 
tained earnings, in the first case, and $100 of built-in (unrealized) 
gain, in the second case. In both cases, the corporation has a $10 
basis in nondepreciable assets (e.g., land) originally purchased for 

and (F) mere changes in identity, form, or place of organization. (See also section 368(a)(1)(G), 
which relates to reorganizations involving certain financially-troubled companies). 

$10, and there are no deductions or credits that are subject to re- 
capture. In both cases the market value of the corporate assets is 
$110 — $10 of basis plus $100 of retentions or built-in gain, respec- 
tively. The corporation is subject to tax at a 46-percent rate on or- 
dinary income and at a 28-percent rate on capital gain. Sharehold- 
ers, who have a $10 total basis in their stock, are subject to tax at a 
50 percent rate on ordinary income and at a 20 percent rate on 
capital gains. 

In the first case, the shareholders wish to realize the $100 of cor- 
porate retained earnings (on which the corporation may or may not 
have paid taxes). If the corporation distributes a $100 dividend, 
shareholders will be liable for $50 of income tax (see Table 3). Al- 
ternatively, the shareholders might sell their stock for $110 in cash 
to an acquiring corporation in a taxable stock acquisition or have 
the corporation do a liquidating sale under secton 337. Either case 
would result in $20 of capital gains tax liability for the sharehold- 
ers, on their $100 in gain, and no corporate tax. Finally, the share- 
holders might exchange their shares for $110 worth of stock in an 
acquiring corporation pursuant to a qualified reorganization. In 
that case, the shareholders would take a substituted basis in the 
stock received from the acquiring corporation and defer tax on 
their gain (perhaps forever). Thus, as shown in Table 3, the "distri- 
bution" of $100 of corporate income can have tax results ranging 
from $20 of deferred tax liability to $50 of current tax liability, de- 
pending on the form of the transaction. 

Table 3. — Tax on the Realization of $100 of Retained Earnings 





sec. 338 
tion 1 


sec. 338 


Corporate tax 

Shareholder tax $50 $20 $20 ^$20 

Total tax 50 20 20 20 

1 The same tax results generally flow from a liquidating sale under section 337. 

2 Tax is deferred until sale of shares and will be fully forgiven if the stockholder 
dies before disposing of them. 

In the second case, the shareholders wish to realize the $100 ap- 
preciation in corporate assets. The corporation could simply sell 
the appreciated asset and distribute the net after-tax proceeds to 
the shareholders in an ordinary distribution. If the transaction was 
not structured as a complete liquidation under section 337^^, then 
the appreciation would be taxed at both the corporate and share- 
holder levels. In that event, the sale would trigger $28 of corporate 

'^ This would be the case if the $100 of appreciation were distributed and later, in an unrelat- 
ed transaction, a $10 liquidating distribution were made. 


tax (assuming the asset was a long-term capital asset), and the dis- 
tributions would total $82 ($110 less $28), of which $10 would be a 
return of basis to the shareholders and $72 would be a nonliquidat- 
ing distribution. The shareholders would be liable for $36 of tax on 
the nonliquidating distribution, so the total corporate and share- 
holder tax would be $64 (see Table 4). Alternatively, if the assets 
were sold pursuant to a plan of complete liquidation, corporate tax 
would be escaped (under the General Utilities doctrine and sec. 
337), and the only tax would be $20 on the shareholders' $100 gain. 
The same tax consequences would flow from a $110 taxable stock 
acquisition subject to a section 338 election. However, if a section 
338 election were not made, then the acquiring corporation might 
be willing to pay only $82 for the target's shares, because the ac- 
quirer eventually will be liable for $28 of gains tax when the asset 
is sold. Under these assumptions, the shareholders would recognize 
$72 of gain ($82 less $10) and incur current tax liablity of $14.40 
(.20 times $72). Finally, the same tax consequences would flow from 
an exchange of shares worth $82 in a tax-free reorganization 
except that the target's shareholders could defer recognition of 
their gain. 

Table 4.— Tax on the Realization of $100 of Appreciation 








sec. 338 
tion 1 


sec, 338 


Corporate tax $28 

Shareholder tax 36 

Total tax 64 

2 $28.00 2 $28.00 
$20 14.40 3 14.40 

20 42.40 42.40 

1 The same results generally would flow from a liquidating sale under section 

^ Corporate tax is deferred until gain in assets is realized. 

^ Shareholder tax is deferred until shares are sold or forgiven if the shareholder 
dies holding them. 

These examples show that the General Utilities doctrine, sections 
337 and 338, and the tax-free reorganization rules create opportuni- 
ties whereby shareholders can realize corporate earnings and built- 
in gains with less than full current taxation at both the corporate 
and shareholder levels. 

2. Churning mergers 

The Code also provides some incentive for mergers designed to 
minimize tax on corporate assets by churning, i.e., selling property 
when most of its cost has been recovered through depreciation de- 
ductions. In a liquidating sale pursuant to section 337 (or in a tax- 
able stock acquisition pursuant to a section 338 election), the buyer 


steps up the depreciable basis of acquired property to cost and the 
seller may be subject to recapture tax but not tax on other gain. 
For example, in the case of section 1250 property, there will in 
many cases be no recapture tax liability. T'hus, if a target corpora- 
tion that holds fully-depreciated section 1250 property is acquired 
in a transaction qualifying for step-up treatment, then the buyer 
will obtain a fresh depreciable basis, often with no tax to the seller. 
In this manner, the tax benefits of ACRS straight-line depreciation 
for real property can be magnified by the repeated churning of cor- 
porate assets. The benefits of churning can also be obtained by non- 
liquidating sales of assets. However, the Code favors section 337 
and section 338 transactions because they frequently allow the 
seller to escape tax on gain. 

3. Leveraged mergers 

The preceding analysis has shown that mergers can be used to 
distribute assets from corporate solution and to churn the tax bene- 
fits of assets. A third tax-advantaged use of mergers is to increase 
the amount of debt in a target's financial structure ("leverage"). 

The advantages of debt financing can be illustrated by comparing 
2 corporations with $1,000 of assets that are identical except for fi- 
nancial structure: the first is entirely equity financed; while the 
second is 50 percent debt financed. Both corporations earn $200 of 
operating income. The all-equity corporation pays $92 in corporate 
tax and retains or distributes $108 of after-tax income ($200 less 
$92). Thus, as shown in Table 5, the return on equity is 10.8 per- 
cent ($108 divided by $1,000). 

Table 5. — Effect of Debt Financing on Stock Yield 

All eauitv 50-percent 
Item Aii-equiiy debt-financed 
corporation corporation 

Balance sheet 

Total assets $1,000 $1,000.00 

Debt 500.00 

Shareholders' equity 1,000 500.00 

Income statement 

Operating income 200 200.00 

Interest expense 70.00 

Taxable income 200 130.00 

Income tax 92 59.80 

Income often corporate tax 108 70.20 

Return on equity^ (percent) 10.8 14.04 

^ Return on equity is computed as income after corporate tax divided by 
shareholders' equity. 

As indicated, the leveraged corporation is financed by $500 of 
debt and $500 of stock. If the interest rate is 14 percent, then inter- 
est expense is $70 (.14 times $500). Taxable income is $130 after de- 
ducting interest expense. The leveraged corporation is liable for 
$59.80 in corporate tax (.46 times $130) and distributes or retains 


$70.20 of after-tax income ($130 less $59.80). Consequently, the 
return on equity is 14.04 percent ($70.20 divided by $500). Thus, as 
shown in Table 5, increasing the debt ratio from zero to 50 percent 
increases the rate of return on equity from 10.8 to 14.04 percent. ^^^ 
In summary, the Code encourages leveraged acquisitions to the 
extent that the managers of target corporations fail to exploit the 
tax advantages of debt financing. This may occur where managers 
are more adverse to bankruptcy risk than shareholders because, for 
example, their careers are jeopardized by bankruptcy. The Code 
also encourages the use of debt as payment in exchange for target 
stock because shareholders may use the installment method of re- 
porting to defer capital gains tax. 

4. Tax benefit transfer mergers 

Generally, the Code prohibits the direct sale of tax benefits from 
one corporation to another, requiring instead that tax benefits 
reduce the tax liability of the corporation that generated the bene- 
fit. For example, deductions for net operating and built-in losses 
cannot be sold. Nor can excess tax credits. However, in certain cir- 
cumstances, tax benefits can be acquired indirectly by means of a 
properly structured merger. Section 269 seeks to discourage merg- 
ers designed principally for tax purposes. In addition, sections 382 
and 383 and the consolidated return rules generally seek to pre- 
vent buyers from using the target's tax benefits to reduce tax li- 
ability from unrelated assets. Nevertheless, there are a number of 
techniques which may allow an acquiring corporation to use a tar- 
get's tax benefits more rapidly than the target. ^^ 

5. Other tax-motivated mergers 

The preceding analysis has concentrated on the use of mergers in 
executing tax planning strategies designed to distribute corporate 
income, churn tax benefits, increase debt financing, and transfer 
tax benefits. Tax-motivated mergers may also occur in other situa- 
tions. For example, tax-free reorganizations are a useful device in 
estate-tax planning for avoiding the illiquidity and valuation prob- 
lems associated with stock in a closely-held corporation. 

6. Tax barriers to merger 

While there are many cases in which the Code appears to en- 
courage mergers, there are also instances where the Code inhibits 
the combination of assets. The Code serves as a barrier to merger 
where shareholders in a potential target hold stock with substan- 
tial appreciation and the merger is not structured as a tax-free re- 
organization. In this case, the exchange of stock in the target for 
cash or stock in the acquiring corporation will trigger tax on the 
gain built into the target stock. An otherwise economically efficient 
combination of assets might not take place because of adverse tax 
consequences. Thus, the Code may contribute to economic ineffi- 

' 3" More generally, the return on equity rises with increasing debt capitalization so long as 
the interest rate is less than the pre-tax rate of return on corporate assets. 

'* For example, a company with net operating losses can acquire a profitable company and 
use its losses to reduce the target's tax liability. Similarly, a profitable company may acquire a 
target's NOLs in a qualified stock reorganization and subsequently transfer some of its income- 
generating assets to the target in an attempt to avoid the consolidated return rules. 


ciency not only by encouraging inefficient mergers but also by dis- 
couraging efficient asset combinations. 

C. Policy Implications of Tax-Motivated Merger Activity 

The principal tax policy issues raised by tax-motivated mergers 
appear to be: (1) whether the effect of the tax Code on the volume 
and type of merger activity is harmful; and (2) whether the tax 
Code should be used to encourage or discourage certain types of 
merger or merger tactics. 

Although there is little conclusive evidence, a number of experts 
have concluded that the Code has tended to increase the volume of 
merger activity. In one study, tax considerations were found to be 
the major reason for over one-fourth of the mergers during the 
period 1940-47.^^ This finding may be cause for concern because, 
from the standpoint of economic efficiency, mergers undertaken for 
tax reasons may not be justified. 

Some have argued that the efficiency gains from the current 
merger wave are likely to be large based on studies showing that 
stock prices increase substantially after merger.^® However, it is 
possible that a large portion of the stock price gain is in fact due to 
the capitalization of tax benefits arising from the merger. Obvious- 
ly, if tax benefits explain the increase in stock price, then it cannot 
be concluded, from this evidence alone, that mergers increase effi- 
ciency. Also, the stock market gains associated with mergers 
appear to be ephemeral — disappearing altogether in the year after 
acquisition. ^ '^ 

While acknowledging that the economy would be better off with- 
out certain tax-motivated mergers, it has been argued that mergers 
used as a means of selling tax attributes, such as net operating 
losses and excess credits, may be beneficial. ^^ The argument is that 
firms are more willing to undertake risky investments knowing 
that in the event of failure, some portion of loss and credit car- 
ryovers can be sold in a merger. However, after an investment has 
failed, there is generally no efficiency rationale for mergers de- 
signed to traffic in losses. Furthermore, the use of mergers to 
transfer tax benefits is a cumbersome and costly approach. 

Others contend that, in the absence of evidence demonstrating 
that mergers are generally beneficial to the economy, tax policy 
should be "neutral" with respect to mergers and acquisitions. 
Mergers would in this case be based more on efficiency consider- 
ations (provided that antitrust enforcement is effective in prevent- 
ing mergers that would create monopoly power) and more likely to 
increase productivity. However, in altering the tax Code to remove 
incentives for merger, caution would need to be exercised in order 
to avoid creating excessive tax barriers to mergers. Forcing recog- 
nition of gain in certain corporate acquisitions could result in a 

'* J. Keith Butters, John Lintner, and WilHam L. Gary, "Effects of Taxation: Corporate Merg- 
ers," Harvard Business School (1951). 

'^ See Annual Report of the Council of Economic Advisors, (February 1985), Chapter 6. These 
studies compare the market value of the resulting company with the pre-merger value of both 
the acquiror and the target. 

" See Warren A. Law, "Testimony before the House Committee on Energy and Commerce 
Subcommittee on Telecommunications, Consumer Protection, and Finance" (March 12, 1985). 

'^ Annual Report of the Council of Economic Advisors, (February 1985). 


"lock-in" effect: sale of corporate assets to superior management 
might be discouraged by the triggering of adverse tax results. 

In addition to being concerned about the high volume of merger 
activity in recent years, some believe that offensive and defensive 
tactics employed in takeover contests are harmful to shareholder 
interests and public policy goals. Bidders have been criticized for, 
among other things, the use of "two-tier" tender offers and the is- 
suance of sub-investment grade ("junk") bonds, while defenders 
have been accused of using abusive tactics such as limited share re- 
purchases ("greenmail") and lavish severance contracts triggered 
by takeover ("golden parachutes"). Those who believe mergers are 
disruptive, inefficient, or monopolistic tend to oppose the aggres- 
sive tactics used by bidders, while those who believe that mergers 
promote competition and efficient utilization of resources are more 
worried about tactics used to ward off a hostile takeover. 

The tax Code appears neither to directly encourage nor discour- 
age such techniques as the use of two-tier tender offers or green- 
mail in hostile takeover attempts. The Code encourages debt-fi- 
nanced mergers as a result of the general tax advantage available 
to the debt financing of corporations and the installment method of 
reporting gain on shares exchanged for debt. However, section 279 
seeks to discourage mergers financed by convertible subordinated 
debentures, although the scope of this provision is narrow. Finally, 
the attractiveness of golden parachutes was reduced by the Deficit 
Reduction Act of 1984. 

While the harmfulness of certain takeover tactics is a controver- 
sial issue, there are a number of possible remedies other than tax 
Code amendments. If it deemed it proper. Congress could amend 
the securities laws to regulate certain takeover tactics. In addition, 
shareholders can amend corporate charters to prevent manage- 
ment from engaging in defensive tactics that might reduce their 
chance to benefit from a generous tender offer. Shareholders can 
also challenge defensive strategies that are not in their interest 
through the courts. 

D. Proposals for Change 

Tax-motivated mergers result from both the general rules of the 
Code regarding the measurement of income from capital as well as 
specific provisions regarding the taxation of acquisitions. Some 
have argued that the difficulties in accurately defining income 
from capital (e.g., depreciation, adjustment of basis for inflation, 
and recognition of unrealized capital gains) are so severe that a 
system which attempts to tax such income will inevitably create 
distortions such as tax-motivated mergers. ^^ On these grounds, it 
has been argued that the only complete solution is to replace the 
current income tax with a consumption tax, such as the cashflow 
tax described by the Treasury Department in a 1977 study or a Eu- 
ropean style value-added tax.^o 

^® See for example, Avinash Dixit, "Tax Reform as Industrial Policy," Princeton University, 
(December 1984). 

2° Dept. of the Treasury, Blueprints for Basic Tax Reform, (January 17, 1977). A related pro- 
posal is discussed in Robert Hall and Alvin Rabushka, Low Tax, Simple Tax, Flat Tax, (1983). 


The Treasury Department's recent tax reform proposal examines 
these issues in great detail. The Treasury proposal rejects adoption 
of a consumption tax and, instead, recommends comprehensive 
changes in the income tax which would, inter alia, more accurately 
measure income (especially during periods of high inflation), re- 
lieve double taxation of dividends, and eliminate tax preferences. ^^ 
These provisions would greatly limit the usefulness of mergers as a 
tax planning device for distributing corporate income, churning de- 
preciable property, increasing debt financing, and transferring tax 

A substantial reduction in mergers motivated, at least in part, by 
tax considerations might also be achieved by a reform of the 
income tax provisions specifically relating to mergers. A proposal 
to reform the taxation of corporations, published by the Senate Fi- 
nance Committee staff in 1983, contains a number of provisions 
which might reduce tax incentives for mergers. ^^ The most signifi- 
cant of these, in an acquisition context, are the repeal of the Gener- 
al Utilities doctrine and related rules and the imposition of new 
limitations on the use of loss and credit carryovers by an acquiring 
corporation. Specifically, this proposal would likely reduce the use 
of mergers as devices for distributing corporate income and trans- 
ferring tax benefits. However, the proposals would not affect the 
use of mergers to increase debt financing. The proposals would also 
provide elective carryover treatment to avoid creating a "lock-in" 
effect that might discourage economically sound mergers. It would 
also generally provide nonrecognition treatment for the receipt of 
stock by any target shareholder as a part of an acquisition. 

Congress has, in the past, considered proposals to relieve or 
eliminate the double taxation of corporate dividends. Complete cor- 
porate integration, such as the proposal discussed in the the 1977 
Treasury Study, could eliminate many tax-motivated mergers. In 
Western Europe, where merger and acquisition activity is a small 
fraction of that in the U.S., most countries provide substantial 
relief from double taxation. 

A more limited proposal would be to repeal the installment 
method of reporting (sec. 453), which allows the deferral of tax on 
gain when shareholders in the target exchange their stock for read- 
ily nontradable term debt. The recognition of gain might be re- 
quired to the extent that the buyer takes a step-up in basis. 

Recently, bills have been introduced which would deny interest 
deductions on a broader class of debt incurred to finance the acqui- 
sition of corporate stock or assets and impose tax penalties on pay- 
ments of certain targeted share repurchases ("greenmail"). While 
these proposals address the most glaring symptoms of the current 
merger boom, they do not directly address a number of the root 
causes of tax-motivated mergers. This raises the question of wheth- 
er tax-motivated merger activity would be reduced or, instead, al- 
ternative strategies devised for completing corporate acquisitions. 
For example, any "junk" bond rule might be fairly easily avoided. 

^' Dept. of the Treasury, Tax Reform for Fairness, Simplicity, and Economic Growth, 3 vols., 
(November 1984). 

^^ Staff of the Senate Committee on Finance, Tax Reform and Simplification of the Income 
Taxation of Corporations, S. Prt. 98-95, 98th Cong., 1st Sess., (September 22, 1983). 


In conclusion, proposals for change range from comprehensive 
tax reform to legislation designed to discourage specific takeover 
tactics. (See generally part five.) 


This part describes the tax profiles of various potential acquired 
corporations and various potential acquiring corporations or 
groups. It then indicates particular acquisition transactions that 
would appear to be the most beneficial to the parties from a Feder- 
al income tax standpoint under present Code rules. The objective of 
this part is to inform the reader who is not an expert in the intri- 
cacies of subchapter C of the Code of (1) some of the tax benefits 
available in an acquisitions context, and (2) techniques authorized 
by the Code to obtain those benefits. Therefore, the cases described 
(which are not all-inclusive) are simplified cases, designed more to 
present general principles than to identify actual transactions. 
Part four contains a more technical exposition of many of the tax 
rules involved. 

It is not intended to suggest that factors other than tax factors 
play no role in determining whether an acquisition is undertaken 
and, if so, in what form. Business, antitrust, regulatory, and other 
legal and personal concerns, among other considerations, are fre- 
quently as important, if not more important, than tax matters. On 
the other hand, it is clear that tax considerations are very relevant 
in many acquisitions. Furthermore, if they are not the primary 
reason for an acquisition, they frequently affect the price at which 
it is carried out although there are instances in which the avail- 
ability of tax benefits is uncertain. In such a case, the buyer will 
generally not pay much for them. To the extent they turn out to be 
available, the buyer will have obtained a windfall. 

One additional preliminary comment: section 269 of the Code 
deals with certain acquisitions the principal purpose of which is 
the evasion or avoidance of Federal income tax. Where 269 applies, 
the general effect is to prohibit the evasion or avoidance aimed at. 
In what follows, it is assumed in every case, without inference, that 
section 269 would not be applicable. 

Case (1): Redemptions (share repurchases) with borrowed funds 

Corporation M is a widely-held public company with little out- 
standing debt. It pays substantial taxes but still throws off signifi- 
cant cash flow. It may or may not pay large dividends to its share- 

From a tax standpoint, M should seriously consider borrowing a 
large sum of money and using the proceeds to redeem M stock held 
by some of its shareholders. There would be 2 significant tax ad- 
vantages to such a strategy that would not be available under a 
"business-as-usual" approach. 

First, the transaction could be structured so that any gain of the 
redeemed shareholders attributable to the distribution would be 
capital gain. In contrast, periodic distributions made by M to its 



shareholders would generally be fully taxed to them at ordinary 
income rates as dividends. 

Second, M could deduct the interest it pays or accrues on the bor- 
rowed funds. This would enable M to reduce its taxable income, 
perhaps to an amount approximating zero. If so, its Federal income 
tax liability would go down, and its cash flow could increase signifi- 
cantly. That increased cash flow might be sufficient to enable M to 
cover most of its debt service obligations with respect to the bor- 
rowed funds and retire much of the debt over a period of years (al- 
though M might also sell some of its assets to raise cash to assist it 
to pay off the loan). In substance, non-redeemed (i.e., continuing) 
shareholders would have acquired the stock of the redeemed share- 
holders substantially with pre-tax income. In contrast, had M not 
borrowed money to do the redemption, but used its own funds, the 
redemption would have been financed by M with after-tax income. 

Thus, assume that M has 10 shares outstanding valued on the 
New York Stock Exchange at $100 each for a total of $1,000. The 
corporation has no debt, and its taxable income is $200. At a 46 
percent tax rate, it pays taxes of $92.00, leaving it with a cash flow 
of $108.00. This is $10.80, or 10.8 percent, per share. It may or may 
not use all or part of that $108.00 to pay dividends to its sharehold- 

Suppose M borrows $500 at 14 percent interest and uses the pro- 
ceeds to redeem one-half (5) of its shares. After this transaction, it 
will have taxable income of $200 less $70 (interest expense), or 
$130. At a 46 percent tax rate, it will pay $59.80 in taxes, leaving it 
with a cash flow (before paying back any principal on the loan) of 
$70.20. That is $16.20 more than the pre-redemption 10.8 percent 
times the 5 shares still outstanding ($70.20 less $54.00). By servic- 
ing part of its capital with tax deductible amounts, the corporation 
will have increased its per share cash flow and, therefore, its per 
share value. 

Case (2): Leveraged buy-out 

If M does not proceed as suggested in Case (1) or a similar fash- 
ion, others may be willing to provide "assistance". Thus a group of 
wealthy individuals, including some M management, may want to 
buy M in a "leveraged buy-out". They are prepared to contribute 
20 percent of the purchase price as equity and have made arrange- 
ments to borrow the remaining 80 percent. The buying group will 
use Corporation MM, a newly-created company, as the acquiring 
vehicle. MM will buy all the stock of M in a taxable transaction. 
Immediately after the acquisition, M will merge into MM. The 
lenders in the transaction will lend the 80 percent to MM. Immedi- 
ately after MM's merger into M, the loan will be secured by mort- 
gages on and pledges of M's former assets now held by MM. Be- 
cause of the interest deductions generated by the borrowing, MM, 
after the merger, may have little, if any, taxable income. As a 
result, MM may be able to service its debt obligations out of a cash 
flow not reduced (or reduced less) by taxes. The buyers hope and 
expect that the loan (principal and interest) can be mostly paid off 
after several years out of that cash flow of MM. If so, M would 
have been acquired largely with its own pre-tax income. 


Case (3): Change in shareholder investment without current tax; 
step-up at death 

Corporation A's assets have a value approximating their tax 
basis. A, an operating service company, has no significant net oper- 
ating loss carryovers or other tax attributes. A has a single share- 
holder, individual X. X, age 75, has a very low basis in his A stock. 
Corporation B wants to acquire A. 

From a tax standpoint, the sensible deal would be for B to buy 
A's assets for cash (perhaps raised through borrowing) or for B and 
A to combine in a tax-free reorganization (with X receiving B stock 
in exchange for his A stock). If B bought A's assets for cash and X 
kept A alive as a personal holding company, A would pay minimal 
tax and X would pay none. Through this personal holding compa- 
ny, X could then make portfolio stock investments and receive 
(after A paid taxes on its investment income) close to a market-rate 
return on an amount equal to the value of A. Thus, A would have 
significantly changed the nature of his holding, from an operating 
service company to a portfolio investment company, without being 
currently taxed on the gain in his stock. (Furthermore, after X's 
death, his heirs,, would inherit his A stock and take a fair market 
value basis in it iinder section 1014. As a result, the appreciation in 
value of the A stock in X's hand might go untaxed forever.) 

If B and A did a tax-free reorganization, with X receiving B 
stock, neitherv A nor X would be taxed. (Again, upon X's death, his 
heirs would take a fair market value in his B stock, and no tax 
would ever have been imposed on the appreciation in X's stock.) 

If, instead, B bought the A assets and A was then liquidated, or 
if B bought the stock of A from X, X could use the liquidation or 
sales proceeds to invest in portfolio stocks. In either such case, 
however, X would be taxed on the appreciation in the value of his 
A stock. 

Case (4): Step-up in basis with no corporate tax; tax-exempt 

Corporation C's assets have a very low basis relative to their 
value. However, they have no depreciation or other recapture po- 
tential. C has no significant net operating loss carryovers or other 
tax attributes. C's sole shareholder, individual Y, has a basis in his 
C stock approximating its value. Corporation^D wants to acquire C. 

From a tax standpoint, a sensible deal would be for D to buy C's 
assets for cash (perhaps raised through borrowing). If D buys C's 
assets, C should liquidate under section 337. Alternatively, D could 
buy all Y's stock in C and make a section 338 election. (If D makes 
a section 338 election, the transaction would generally be treated 
by C as a sale of assets followed by a prompt liquidation under sec- 
tion 337.) In either case, Y would have only nominal tax liability, 
and C, under section 337, would have no tax liability at all with 
respect to the appreciation in value of its assets. Furthermore, D 
would take a "stepped up" tax basis in C's old assets equal to their 
cost (and thus, for example, generally could begin depreciating 
them immediately under ACRS to the extent they were depreciable 
property). As a result, the appreciation in the value of C's assets 
would never be taxed to any corporation. In contrast, if there were 


no acquisition of C, C generally would in the normal course of its 
business pay tax on the appreciation in the value of its assets, and 
any distributions it made to Y generally would be taxed to Y as 
dividend income. ^'^ 

If the parties did a tax-free reorganization, neither C nor Y 
would have any immediate tax liability, but D would inherit C's 
low asset basis and depreciation methods. 

Case (5): Deferral of shareholder gain with installment sale 

The facts are the same as in Case (4) except that individual Y 
has a low basis in his C stock. If a tax-free reorganization is done, 
nobody will pay any current taxes, but D will not get to step up the 
basis of C's assets. But if a cash transaction under section 337 or 
338 is done, Y will have a large current tax liability. An alterna- 
tive would be to have D issue nonreadily tradable term installment 
obligations, bearing a market rate of interest, for the C assets (fol- 
lowed by a section 337 liquidation) or stock (followed by a section 
338 election). Under that approach, D would get an immediately 
usable basis in C's assets in an amount equal to their cost (as well 
as annual interest deductions), and C would have no significant tax 
liability. Furthermore, Y, under section 453, could generally defer 
paying taxes on the appreciation in the value of his C stock until D 
made principal payments on the installment obligations. Mean- 
while, Y would be getting from D market-rate interest on the 
entire principal amount of the obligations (i.e., the sales price). If 
the consideration to Y had been cash, Y could have invested at 
market rates only that amount less the amount of tax currently 
due on his gain. In effect, section 453 would permit Y to obtain an 
interest-free loan from the Federal government. 

Case (6): Avoiding recapture 

Corporation E is a widely-held public corporation. Its assets have 
a tax basis which is very low relative to their value. However, most 
of that difference would be treated as depreciation recapture (or 
similar items) were E to sell its assets for their value. Neither E 
nor Corporation F has any significant net operating loss car- 
ryovers. F wants to acquire E. 

It would not make tax sense for F to acquire E's assets in a tax- 
able transaction or for F to acquire E's stock in a taxable transac- 
tion and make a section 338 election. In either case, F would get a 
step-up in basis for E's assets. However, E would have immediate 
ordinary (recapture) income in an amount approximating that step- 
up. The tax cost of that ordinary income would exceed the present 
value of the basis step up for the E assets. Therefore, F should con- 
sider buying the stock of E and not making a section 338 election 
(in which case the basis of E's assets would not change and E 
would have no taxable income, but the E shareholders would be 
taxed) or doing a tax-free reorganization with E. If such a reorgani- 

^' Suppose, instead, that C's sole shareholder in Case (4) is a tax-exempt organization or a 
foreign person who is not a U.S. taxpayer. Suppose further that that shareholder has a low basis 
in its C stock. Under these facts, C could sell its assets and liquidate under section 337, or D 
could buy the C stock for cash and make a section 338 election. In either event, generally nei- 
ther C nor its shareholder would have any U.S. tax to pay under present law. 


zation were done, again the basis of E's assets would not change, 
but E's shareholders would generally have a tax-free transaction. 

Case (7): Use of acquirer's NOLs 

The facts are the same as in Case (6) except that F (but not E) 
has large net operating loss carryovers that it does not expect to be 
able to use in the normal course of its own operations. In this case, 
F should consider buying all the E stock in a taxable transaction 
and not making a section 338 election, in which case there would 
be no change in the basis of E's assets. Thereafter, F could sell 
some or all of the E assets for their value. Assuming F and E are 
filing consolidated returns, F's net operating loss carryover could 
be used to offset the gain to E on the sale of its assets. E could then 
reinvest the sales proceeds in new assets, which may or may not be 
similar in function. As a result, the new E assets would get a new 
basis, and no corporate tax would ever be paid on the recapture 
income inherent in the old E assets (although E's shareholders 
would be taxed). Alternatively, the parties could do a tax-free reor- 
ganization to the same end. In that case, E's shareholders would 
generally have a tax-free transaction. 

Case (8): Target built-in loss 

Corporation G is a widely-held public company. Its assets have a 
tax basis which is very high relative to their value (i.e., there is 
"built-in loss"), and it is not currently paying taxes. Corporation H, 
which is very profitable and pays substantial taxes, wants to ac- 
quire G. 

H should not buy G's assets in a taxable transaction or buy the 
G stock in a taxable transaction and make a section 338 election. 
In either case, the basis of G's assets would be reduced ("stepped 
down") to their cost, and the benefits of G's built-in loss would dis- 
appear. Rather, H should consider buying G's stock in a taxable 
transaction and not making a section 338 election. In that case, 
while G's shareholders would be taxed, there would be no change 
in the tax basis of G's assets. Assuming G and H file a consolidated 
return after the acquisition, H, subject to several limitations, would 
be able to make use of G's built-in loss through depreciation deduc- 
tions or sales of G assets. Thus, H could receive tax benefits based 
on an amount substantially in excess of what it paid for the G 
stock. This differs from general Code principles, under which tax 
benefits are usually based on cost to the taxpayer. 

Alternatively, G and H could combine in a tax-free reorganiza- 
tion, with similar results. Furthermore, in that case, G's sharehold- 
ers would generally not be taxed currently. 

Case (9): Acquisition by a loss corporation 

Corporation I is a very profitable corporation which pays signifi- 
cant taxes. Its assets have a tax basis approximating their fair 
market value. Corporation J has net operating loss carryovers. J 
wants to acquire I. 

J has substantial tax-planning flexibility. It could acquire the I 
assets in a taxable transaction, it could acquire the I stock in a tax- 
able transaction, or it could acquire I in a tax-free reorganization. 
In any such case, J would be putting itself into a position where it 


could deduct from future taxable income generated by I (or the 
former I assets) its own net operating loss carryovers from periods 
predating the acquisition. 

Case (10): Acquisition of NOLs 

The facts are the same as in Case (9) except that I has significant 
net operating loss carryovers and J pays substantial taxes. J should 
not buy I's assets in a taxable transaction or buy the I stock in a 
taxable transaction and make a section 338 election. If it did, I's 
net operating loss carryovers would not be available to it. Under 
almost any other acquisition form, J could acquire I, including its 
net operating loss carryovers. Subject to some limitations, J could 
then use I's pre-acquisition carryovers to offset its own (or I's) post- 
acquisition taxable income. 

Case (11): Liquidating sales to different buyers 

Corporation Q is a widely-held holding company. Its assets con- 
sist of all the stock of each of 10 operating companies, none of 
which is held as inventory. Q's aggregate basis in that stock is well 
below the aggregate value. An investor group wants to acquire Q 
for cash. It creates newly-formed corporation P, and P buys all the 
stock of Q. P does not make a section 338 election. After the pur- 
chase, P causes Q to make liquidating sales of the stock of each of 
its 10 subsidiaries, for cash to 10 unrelated corporate buyers, each 
buyer buying one subsidiary. Q and P both then liquidate, the in- 
vestor group ending up with the cash received by Q on the separate 
sales of its subsidiaries. 

Under this transaction, generally P and Q would not be taxed de- 
spite the appreciation in value of Q's holdings. The investor group 
would be taxed on any gain, probably at capital gains rates (as 
would shareholders of Q who sold their stock to P). Each of the 10 
different buyers would be able to make an independent judgment 
as to the wisdom of a section 338 election with respect to the stock 
of the subsidiary it just acquired. Some probably would make an 
election, and some would not. 

These results could also have been achieved by Q alone, without 
P's (or the investor group's) participation. 

Case (12): Overfunded pension plan 

Corporation K is a widely-held public corporation. K maintains a 
defined benefit pension plan established for the exclusive benefit of 
its employees. The plan is a qualified plan under section 401, and 
the related trust qualifies for tax exemption. The trust is currently 
overfunded by approximately $100 million. That is, if the trust 
were currently to be terminated, its assets would exceed the 
present value of the benefits accrued under the plan by K employ- 
ees up to the date of plan termination. Corporation L wants to ac- 
quire K. 

Under almost any form of acquisition, L, subject to some limita- 
tions, could cause K to terminate its pension plan. The termination 
would enable L, directly or indirectly, to obtain the $100 million. It 
could be used to assist L in paying for the acquisition, for general 
corporate purposes, or for any other purpose. While the $100 mil- 
lion would be included in the gross income of K (or L) upon termi- 


nation of the plan, any net operating losses and loss carryovers of 
L (or K, depending on the acquisition form) could be used to offset 
that income. 

If K did not desire to be acquired, it would be well-advised to ter- 
minate the plan itself and to make good business use of the pro- 
ceeds. K would be a less attractive takeover candidate in that 
event, for it would not have $100 million in readily-available cash 
as an inducement to a potential acquirer. 

Case (13): Leveraged acquisition 

Another potential buyer of M in Case (1) may be another widely- 
held public company. That company could borrow the money to 
buy M stock. The buying company would deduct its interest ex- 
penses, thus reducing its (and M's) Federal income tax liability and 
increasing cash flow. Again, that increased cash flow would make 
it easier for the borrowed money to be repaid. Again, M would 
have been acquired largely with untaxed income. 

It is possible that the interest deductions on the borrowing would 
not be large enough to fully offset M's post-acquisition taxable 
income. However, in a case like Case (13), the buying company 
could make a section 338 election after acquiring the M stock (as 
could MM in Case (2)). If such an election made tax sense, making 
it would have the effect of reducing post-acquisition taxable 
income. Or the buying company in Case (13) may have net operat- 
ing loss carryovers or current operating losses of its own. If so, it 
could use those to bring post-acquisition taxable income down even 
further. Finally, M's buyer might cause M to transfer its assets to 
a partnership composed of M and an unrelated corporation having 
large loss carryovers. The partnership rules may permit the parties 
to structure the partnership in such a way that substantially all 
income from the former M assets would be offset by the loss com- 
pany's carryovers. If so, little tax would be paid, thus making it 
easier for M's buyer to make debt service payments. 

Case (14): ESOPs 

All the stock of Corporation N is owned by individual Z. Z's basis 
in the N stock is substantially below its fair market value. Z wants 
to sell most of his N stock, and N's employees desire to buy it. Ac- 
cordingly, N can set up an employee stock ownership plan 
C'ESOP") for its employees. N may then borrow an amount equal 
to, say, 80 percent of the fair market value of its stock from a bank 
or an insurance company. The loan may be secured by mortgages 
on and pledges of N's assets. N can then reloan the loan proceeds 
to the ESOP on substantially the same terms on which it borrowed 
them. The ESOP can then use the loan proceeds to buy 80 percent 
of the N stock from Z. The ESOP will pay off the loan with contri- 
butions made to it by N in subsequent years. Z will use the sales 
proceeds to invest in a portfolio of securities of public companies 
traded over the New York Stock Exchange. 

Under section 1042, this transaction would produce no immediate 
tax consequences to Z. Recognition of his gain would be deferred. 
As a result, Z may be willing to sell his N stock for a price lower 
than would otherwise be the case. The bank or insurance company 
lender to N, under section 133, would be able to exclude from its 


gross income 50 percent of the interest income on its loan to N, so 
it should be willing to lend at a favorable rate of interest. And N 
generally could deduct that part of its contributions to the ESOP 
used to pay off principal on its loan to the ESOP. As a result, the 
dollars used to buy the N stock from Z would not be currently tax- 
able to anyone. 

Case (15): Hostile takeovers 

Corporation O is a widely-held public company the stock of which 
is traded on the New York Stock Exchange. The stock is currently 
selling at $40 per share. A group of investors determines that, 
based on the net value of its underlying assets, O is really worth 
$80 per share. The investor group, through a newly-created or an 
existing corporation, begins buying O stock, on the exchange, at 
$40 to $45 per share, largely with borrowed funds. After acquiring 
5 percent of O's outstanding stock, the investor group's corporation 
makes a tender offer, at $60 per share, for the balance of O's stock. 
Most of the cash to be used in the tender offer would be borrowed 
by the tendering corporation. The investor group has financing 
commitments from prospective lenders under which the corpora- 
tion can borrow, on an unsecured and subordinated basis, the funds 
it may need to finance the tender offer at an interest rate of sever- 
al points over prime. The high rate on the debt ("junk" bonds) re- 
flects the credit evaluation made by the prospective lenders. 

The tender offer may be successful. If so, a section 338 election 
could be made, and interest payments would be deducted by the 
new corporation. This could reduce post-acquisition tax liability 
and increase cash flow available to service the debt. 

If O does not wish to be acquired by the investor group, a 
number of other things may happen. Among them are the follow- 
ing 3 possibilities. First, O may try to dissuade the investor group 
from proceeding with the tender offer by offering to buy back the 5 
percent of its stock held by the group. O may offer $60 per share. If 
this "greenmail" offer is accepted, O might claim (based on very 
dubious authority) a tax deduction for the entire $60 per share, and 
the investor group's corporation will probably claim that its profit 
qualifies as capital gain. Second, O may search around for a "white 
knight". If O is successful, it may find a white knight who will buy 
O for $65 per share. Again, the investor group's corporation will 
likely claim capital gain treatment. (What the white knight does in 
the way of acquisition planning (e.g., using borrowed money or 
making a section 338 election) will depend on the tax profiles of O 
and itself.) Third, O may set up an ESOP to buy, with borrowed 
funds, some of its stock. (This would assist O in fending off the ac- 
quisition attempt because the ESOP would likely be less inclined to 
accept the tender offer than would O's public shareholders.) Gener- 
ally, 50 percent of interest payments made by the ESOP with re- 
spect to those borrowed funds would be excludible from the lend- 
er's gross income. Furthermore, O would in effect end up with de- 
ductions for contributions it makes to the ESOP to enable it to am- 
ortize the loan. 


Part two of this pamphlet looked, from a tax policy perspective, 
at how present Code rules may influence whether a corporate ac- 
quisition is done and, if so, in what form. Part three illustrated the 
application of those rules in the context of simplified cases. This 
part discusses, on a more detailed and technical level, many of the 
operative rules. As indicated in parts two and three, most acquisi- 
tions can, from a tax standpoint, be carried out as taxable pur- 
chases of assets, as taxable purchases of stock (with or without a 
secton 338 election), or as tax-free reorganizations. The tax conse- 
quences of the 3 differ greatly. 

A. Forms of Acquisition 

An acquiring corporation can structure the acquisition of an- 
other corporation as a taxable purchase or as a tax-free reorganiza- 
tion. In either case, the transaction can take the form of an acqui- 
sition of assets or an acquisition of stock. As indicated in part 
three, the form of an acquisition is influenced by factors such as 
the nature of the consideration to be used (e.g., cash, or stock or 
debt of a party to the acquisition), the opportunity to step up the 
basis of the acquired corporation's assets, and the question of 
whether it is advantageous to preserve the acquired corporation's 
tax history (e.g., net operating loss carryovers, credit carryovers, 
and built-in losses). 

What follows is a technical description of many of the Federal 
income tax rules that govern corporate acquisitions involving do- 
mestic corporations, including the treatment of shareholders of ac- 
quired corporations. 

1. Taxable acquisitions 

If the consideration used by an acquiring corporation is cash or 
other property (rather than stock of the acquiring corporation or a 
corporation in control of the acquiring corporation), the acquisition 
will be a taxable purchase of the acquired corporation's assets or 
stock. A putative reorganization that fails to qualify for tax-free 
treatment, where the consideration consists of stock or a combina- 
tion of stock and cash (or other property), is also treated as a tax- 
able purchase. 

a. Asset acquisitions 

A taxable sale of assets by a corporation normally results in the 
recognition of gain or loss to the corporation unless the corporation 
liquidates within a prescribed period and satisfies certain other re- 
quirements (discussed below). ^^ The acquiring corporation takes a 

^* This case usually involves nothing more than the sale by a corporation of only some of its 
assets and its continuation in business. It is not a corporate acquisition at all. 



cost basis for the acquired assets (generally equal, in the aggregate, 
to the amount of cash and the fair market value of any property 
used as consideration). No gain or loss is recognized by the share- 
holders of the selling corporation unless the corporation distributes 
all or part of the sale proceeds. 

Treatment of selling corporation 

The selling corporation in a nonliquidating sale recognizes gain 
or loss equal to the difference between the amount realized (i.e., 
the cash and the value of any property received) and its basis with 
respect to each asset. Recognized gain or loss is ordinary income or 
loss, long-term capital gain or loss, or short-term capital gain or 
loss depending on the nature and holding period of the transferred 
property. For example, if the selling corporation recognizes a net 
gain from depreciable assets that were used in its trade or business 
and held for the period required (generally more than 6 months), 
then the gain may be taxed as long-term capital gain pursuant to 
section 1231. Ordinary income and net short-term capital gain are 
taxed to corporations at a maximum rate of 46 percent. A corpora- 
tion's net capital gain (the excess of net long-term gain over net 
short-term loss) is subject to an alternative tax of 28 percent if the 
tax computed using that rate is lower than the corporation's tax 
would be using the regular rates. 

Recaptures. — Part or all of the selling corporation's gain may be 
characterized as ordinary income under a "recapture" provision. 
The recapture rules, and similar rules, are generally designed to 
prevent the conversion of ordinary income into capital gain by re- 
quiring gain on disposition of certain property to be taxed as ordi- 
nary income to the extent of deductions previously taken against 
ordinary income with respect to the property. 

Under the depreciation recapture rules of section 1245, gain is 
taxed as ordinary income to the extent of all prior depreciation de- 
ductions taken with respect to personal property. Under section 
1250, if part or all of the cost of nonresidential real property quali- 
fying as recovery property was recovered under the accelerated de- 
preciation method, recognized gain is treated as ordinary income to 
the extent of all prior recovery deductions taken. On the other 
hand, if the property was not depreciated under an accelerated 
method, none of the gain is recapture income. Section 1252 pro- 
vides a recapture rule for transfers of farm land. Under this provi- 
sion, a portion of the post-1969 amounts deducted for soil and water 
conservation or clearing land is subject to recapture. 

If mining property is included in the assets disposed of, recog- 
nized gain is treated as ordinary income to the extent of post-1965 
mining exploration expenditures previously deducted under section 
617 (reduced by the amount of foregone depletion deductions). Simi- 
larly, if oil and gas properties are sold, section 1254 provides for 
the recapture of amounts deducted for post- 197 5 intangible drilling 
and development costs (less the amount of foregone cost depletion 
deductions). Section 1254 also applies, with respect to post-1977 de- 
velopment costs, to transfers of geothermal property. However, de- 
pletion deductions are not subject to recapture. 

In addition to the recapture of previously claimed deductions. 
Section 47 provides for the recapture of investment tax credits. If 


eligible property is disposed of prior to the end of the period that 
was taken into account in computing the credit claimed by the tax- 
payer, then the credit is recomputed. For example, in the case of 
property that qualified for the regular 10 percent credit, on an 
early disposition, the credit is recomputed by allowing a 2-percent 
credit for each full year the property was held. The difference be- 
tween the credit originally claimed and the recomputed credit is 
generally treated as a doUar-for-doUar increase in the selling corpo- 
ration's tax liability for the year of sale. This recapture occurs 
whether the property is sold at a gain or at a loss. 

Sales by liquidating corporations. — In the acquisition context, a 
corporation selling assets can, under section 337, avoid the recogni- 
tion of gain (other than recapture and similar income) with respect 
to sales that occur within a 12-month period beginning on the date 
the corporation adopts a plan of complete liquidation by distribut- 
ing all of its assets (less assets retained to meet claims) during such 
12-month period. Nor will it recognize loss with respect to any such 
sales. Section 337 generally does not provide nonrecognition treat- 
ment on a sale of assets by a corporate subsidiary, however, unless 
all corporations in the chain above the subsidiary are also liquidat- 
ed. Nor does section 337 generally apply if the corporation is a "col- 
lapsible corporation" (discussed below). 

Ordinarily, the selling corporation recognizes neither gain nor 
loss on liquidating sales of assets (or on the distribution of its 
assets in a complete liquidation ^^). However, gain is recognized (as 
ordinary income) to the extent of recapture income under the rules 
described above. In addition, if the selling corporation maintained 
inventories using the LIFO (last-in-first-out) method for Federal 
income tax purposes, the corporation will recognize ordinary 
income in an amount equal to the excess of the value of the inven- 
tory using the FIFO (first-in-first-out) method over the value using 
the LIFO method. Furthermore, the corporation will recognize 
income on piecemeal liquidating sales of its inventory. Finally, in- 
vestment tax credits are also subject to recapture, as described 

In addition to the statutory recapture provisions, the selling cor- 
poration may be viewed as recognizing income on a liquidation (or 
a liquidating sale) under the "tax benefit" doctrine or assignment 
of income principle. For example, the U.S. Supreme Court has ap- 
plied the tax benefit doctrine to tax a liquidating corporation on 
the distribution of previously expensed items to its shareholders. 
United States v. Bliss Dairy, Inc., 460 U.S. 370 (1983), rev'g, 645 

^^ Prior to the enactment of the Deficit Reduction Act of 1984, generally no gain (other than 
recapture income) was recognized to a corporation that made a nonliquidating distribution of 
appreciated property with respect to its stock. There were several cases under prior law where 
the failure to tax currently the ordinary, nonliquidating distribution of appreciated property to 
a shareholder resulted in tax avoidance. For example, in several-widely publicized transactions, 
publicly-held oil companies transferred royalty interests carved out of long-held working inter- 
ests in oil and gas leases to a trust and distributed units of interest in the trust to their share- 
holders without paying any corporate-level tax (except on recapture). Under the 1984 Act, nonli- 
quidating distributions of appreciated property to corporate shareholders are taxable to the dis- 
tributing corporation. Ordinary distributons to noncorporate shareholders are also taxed to the 
distributing corporation with limited exceptions. However, except for recapture, liquidating dis- 
tributions are not taxable events to distributing corporations. In addititwt, under the 1984 Act, 
the basis of a corporate shareholder's stock is reduced by the nontaxed portion of an extraordi- 
nary dividend (sec. 1059). 

F.2d 19 (9th Cir. 1981). Tax benefit recapture could also apply to 
require the recognition of income with respect to other items such 
as bad debt reserves. 

Similar rules apply in the case of certain taxable stock purchases 
if a section 338 election is made (discussed below). In fact, most tax- 
able acquisitions are cast as stock purchases. By using a stock pu- 
chase, the acquirer can more easily and deliberately assess the 
wisdom of a section 338 election. In the liquidating sale case, there 
is no decision to be made — the transaction will be treated as if such 
an election had been made. 

Consequences to acquiring corporation 

The acquiring corporation in a taxable purchase of assets takes a 
cost basis in the acquired assets (sec. 1012). Thus, for example, if 
appreciated assets are purchased, the basis of the assets are 
stepped up to reflect the acquiring corporation's cost, regardless of 
whether the selling corporation is taxed on the appreciation in the 
value of those assets. Similarly, if the assets purchased have depre- 
ciated in value, the basis is "stepped down" in the hands of the ac- 
quiring corporation. The acquiring corporation will not succeed to 
the tax history (e.g., carryovers) of the selling corporation. 

The value of a stepup depends, in part, on the nature of the ac- 
quired corporation's assets. For example, because land is not depre- 
ciable, the benefit of stepping up its basis is generally realized only 
on a subsequent disposition of the property (by reducing taxable 
gain). On the other hand if the basis of a depreciable asset is 
stepped up, the acquiring corporation will be entitled to larger de- 
preciation deductions than would have been allowed to the selling 
corporation. Likewise, a stepup in the basis of inventory will even- 
tually be reflected in the acquiring corporation's cost of goods sold 
(and thereby reduce its taxable income). 

Shareholders of selling corporation 

In general, the sale of a corporation's assets does not generate a 
tax at the shareholder level. However, if the selling corporation 
distributes the sale proceeds in a complete liquidation, each of the 
corporation's shareholders recognizes gain or loss (generally capital 
in nature) equal to the difference between the value of the liquidat- 
ing distributions and the basis of the stock (sec. 331). 

Possible application of collapsible corporation rules. — The "col- 
lapsible corporation" rules are designed to prevent the conversion 
of ordinary income into capital gain by engaging in an activity 
through a corporation and, before a substantial amount of the re- 
sulting income is realized at the corporate level, disposing of the 
stock in the corporation at a price that reflects the unrealized 
earnings (sec. 341). A shareholder who receives a liquidating distri- 
bution from, or sells stock in, a collapsible corporation is generally 
taxed at ordinary income rates if the gain recognized would other- 
wise be treated as long-term capital gain. Individuals are taxed on 
long-term capital gains at a maximum rate of 20 percent. The max- 
imum rate of tax on ordinary income and net short-term capital 
gain of individuals is 50 percent. 


b. Stock acquisitions 

A taxable purchase of a corporation's stock from its shareholders 
results in the recognition of gain or loss by such shareholders. Gain 
on stock sales is generally taxed at capital gain rates unless the 
collapsible corporation rules (discussed above) apply or the stock 
was not held as a capital asset. Absent an election to treat the 
stock purchase as an asset acquisition under section 338 (described 
below), no gain or loss is recognized by the acquired corporation, 
and the basis of its assets and its tax history are unaffected. How- 
ever, the acquiring corporation takes a cost basis in the purchased 

In the case of widely-held acquired corporations, a common prac- 
tice is for the acquiring corporation to tender for all of the ac- 
quired corporation's outstanding stock and, after purchasing a sig- 
nificant portion of that stock for cash (or installment debt), to 
cause a newly-formed subsidiary to merge into the acquired corpo- 
ration under applicable state law (a "squeeze out" merger). In the 
merger, the acquired corporation's remaining shareholders will 
also receive cash (or installment debt) for their shares. A reverse 
merger of this type is generally treated as a taxable purchase of 
the acquired corporation's stock (but see the discussion below re- 
garding tax-free reverse subsidiary mergers). 

Treatment of the acquired corporation 

The acquisition of part or all of a corporation's stock is generally 
a nonrecognition event for the corporation. Thus, the basis of the 
acquired corporation's assets is unchanged. Similarly, there is no 
effect on other tax attributes such as accumulated earnings and 
profits. Assuming that the transaction does not run afoul of section 
269 (which authorizes the disallowance of certain benefits and de- 
ductions if the principal purpose of an acquisition was tax avoid- 
ance), net operating loss carryovers and unused tax credits, etc. 
will remain fully available to the acquired corporation if it contin- 
ues to carry on a trade or business that was conducted before the 
acquisition (sees. 382 and 383). ^^ Furthermore, any built-in loss of 
the acquired corporation will survive. Thus, the acquired corpora- 
tion generally retains the ability to reduce taxes that would other- 
wise be paid with respect to future income. 

Stock acquisitions treated as asset acquisitions. — A corporation 
that makes a "qualified stock purchase" (the acquisition of at least 
80 percent of another corporation's voting stock and at least 80 per- 
cent of all other classes, excluding nonvoting preferred, within a 
specified time period) can elect to treat the stock purchase as a 
direct purchase of the assets of the acquired corporation (sec. 338). 
If a section 338 election is made, the acquired corporation is gener- 
ally treated as if it had adopted a plan of complete liquidation and 
sold all of its assets at the close of the acquisition date under sec- 
tion 337. The acquired corporation is deemed to have sold its assets 

2 6 Section 382 imposes special limitations on the use of NOL carryovers following an acquisi- 
tion. Section 383 provides similar limitations on attributes other than NOL carryovers. The 
rules are sometimes criticized as too generous to taxpayers and as technically flawed. 1976 
amendments to the rules are generally scheduled to go into effect for taxable years beginning 
after 1985, but they are under reconsideration. 


for a price equal to their fair market values. Nonrecognition treat- 
ment is generally provided to the acquired corporation to the same 
extent that gain or loss would go unrecognized if there were an 
actual sale and liquidation subject to section 337 (see the discussion 
above). Thus, for example, as in the case of a liquidating sale, the 
recapture rules are fully applicable. 

As of the day following the acquisition date, the acquired corpo- 
ration is treated as a new corporation that purchased all of the 
assets held by the acquired corporation. Thus, the basis of each of 
the acquired corporation's assets is generally stepped up (or down) 
to its cost to the acquiring corporation (measured by the price paid 
for the stock and adjusted for liabilities of the acquired corporation 
and other relevant items). ^'^ In addition, the acquired corporation's 
tax attributes are unavailable to the acquiring corporation. 

Consequences to acquiring corporation 

The acquiring corporation takes a cost basis for the purchased 
stock. Although the acquiring corporation does not directly succeed 
to the tax history of the acquired corporation, it can benefit indi- 
rectly from attributes such as NOL carryovers if the acquired cor- 
poration joins the acquiring company in the filing of a consolidated 
return for Federal income tax purposes and if no section 338 elec- 
tion is made or deemed made. If the acquired corporation is subse- 
quently liquidated into the acquiring corporation, the acquired cor- 
poration's tax history will carry over to the acquiring corporation 
(unless the principal purpose of the transaction was tax avoidance). 

Consolidated returns. — Generally, if, after the acquisition, the ac- 
quired corporation is included in an affiliated group of corporations 
that files a consolidated return, the other corporations in the affili- 
ated group can deduct their post-acquisition losses against the ac- 
quired corporation's post-acquisition income. Conversely, losses re- 
alized by the acquired corporation after the acquisition (other than 
certain built-in losses, described below) will offset post-acquisition 
income generated by other members of the affiliated group. 

In addition to the special limitations on NOL carryovers in sec- 
tion 382, under the "separate return limitation year" (SRLY) rules 
provided by regulation (see Treas. regs. sec. 1.1502-21(c)), NOL car- 
ryovers of a newly-acquired member of an affiliated group cannot 
offset income of other members of the group. (The "consolidated' 
return change of ownership" rule provides similar treatment with 
respect to the NOL carryovers of an affiliated group acquired by 
certain persons.) Because an acquired corporation is permitted to 
use NOL carryovers to offset "its own" income, the SRLY rules can 
frequently be avoided by diverting income-producing activities (or 

" Prior to the enactment of the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), a 
corporation could in some instances acquire the stock of another corporation in a taxable pur- 
chase and then effect asset stepups only with respect to selected assets where a stepup was most 
advantageous. This selectivity was achieved by causing a partial liquidation of the acquired cor- 
poration. TEFRA modified the treatment of a partial liquidation so that only certain noncorpor- 
ate shareholders of the distributing corporation would be treated as receiving amounts distribut- 
ed in partial liquidation as in exchange for stock. One of the principal effects of this change was 
to deny an acquiring corporation a stepup in the basis of properties distributed to it by a newly- 
acquired corporation in partial liquidation. TEFRA also adopted other rules which attempted to 
prohibit "selective" stepups, e.g., the consistency rules of section 338. 


contributing income-producing assets) from elsewhere in the group 
to a newly-acquired corporation (but see sec. 269). 

Applicable Treasury regulations (see Treas. regs. sec. 1.1502-15) 
also prohibit the use of an acquired corporation's built-in losses to 
reduce the post-acquisition taxable income of other members of an 
affiliated group. Under the regulations, built-in losses are subject 
to the SRLY rules. In general, built-in losses are defined as deduc- 
tions or losses that economically accrued prior to the acquisition 
but are recognized for tax purposes after the acquisition, including 
depreciation deductions attributable to a built-in loss (Treas. reg. 
sec. 1.1502-15(2)). For example, if the acquired corporation owns a 
building with a basis of $100 and a value of $50 as of the acquisi- 
tion date, the $50 potential loss may be treated as a built-in deduc- 
tion. The built-in loss limitations do not apply unless, among other 
things, the aggregate basis of certain assets of the acquired corpo- 
ration exceeds the value of those assets by more than 15 percent. 
Further, assuming that section 269 is inapplicable, the application 
of the SRLY rules to built-in losses can be avoided by causing the 
acquired corporation to generate additional taxable income (as de- 
scribed above). 

Subsidiary liquidations. — Absent a section 338 election, and as- 
suming no significant tax avoidance motive, a corporation can liq- 
uidate a newly-acquired subsidiary corporation and directly succeed 
to the acquired corporation's tax attributes (sees. 332 and 381). No 
gain or loss is recognized, and no recapture occurs, to the liquidat- 
ing subsidiary corporation or to the distributee parent corporation 
(sees. 332 and 336), and the distributee corporation takes a carry- 
over basis in the assets received on liquidation (sec. 334). The ac- 
quiring corporation's basis in the purchased stock will 'disappear". 

Section 381 enumerates tax attributes that carry over to a parent 
corporation as the result of the liquidation of a subsidiary. A major 
item is earnings and profits or a deficit in earnings and profits. In 
general, a deficit in an acquired corporation's earnings and profits 
cannot be applied against the acquiring corporation's accumulated 
earnings and profits; however, the deficit can reduce the acquiring 
corporation's post-acquisition earnings and profits. Thus, even if 
the acquiring corporation at the time of the acquisition has accu- 
mulated earnings and profits, after such earnings and current 
earnings are paid out as dividends the acquired corporation's defi- 
cit could result in the future payment of tax-free dividends (treated 
as a return of capital to the acquiring corporation's shareholders). 
Of course, the acquired corporation's deficit in earnings and profits 
may be unimportant if the acquiring corporation's accumulated 
earnings and profits are so great that there is no likelihood of re- 
ducing them to zero. 


(1) The opportunity to step up basis 

The parties to an acquisition may or may not wish to step up the 
basis of the acquired company's assets. As indicated, there is a tax 
cost (or "toll charge") to such a stepup — recapture income to the 
acquired company. As the examples below show, there will be 
many cases in which a step-up election is not advantageous. Since 


those stepup and toll charge results are automatic in the case of a 
liquidating sale of assets by an acquired company, most taxable ac- 
quisitions are structured as purchases of stock. In a purchase of 
stock, stepup and recapture will occur only if the parties so elect. 
Further, the law gives the parties some period of time to determine 
whether the election should be made. 

The decision to elect to step up the basis of all assets and pay 
recapture taxes or, alternatively, to have basis carry over and have 
no recapture tax, generally is determined with reference to several 
tax and financial attributes of the acquiring corporation and the 
acquired corporation. The following example illustrates the net tax 
benefits and costs of a step-up election under a limited and simple 
set of assumptions. 

Assume that the acquired corporation acquired all its assets on 
January 1, 1981, and that all its stock is sold on January 1, 1984. 
Five types of assets are involved in the transaction: 

(1) Section 1245 equipment, in the 5-year ACRS class; 

(2) Section 1250 structures, depreciated under the straight- 
line method; 

(3) Section 1254 intangible drilling costs (three-tenths of 
which would have been recovered through cost depletion); 

(4) Lease acquisition costs (three-tenths of which have been 
recovered through cost depletion); and 

(5) LIFO inventories. 

Both parties are assumed to be fully taxable at a 46-percent mar- 
ginal rate. The acquired corporation has no liabilities. (See Table 

Table 6. — Asset Analysis and Recapture Tax 

Jan. 1, 1984— 



Assets cost- T^^ Pur- ^^^^^_ ^^^^p. 

'?98l' "-- prfce ,t«re ture tax 

Section 1245 

equipment $10,000 $4,200 $8,000 $3,800 $1,748 

Section 1250 structures .. 10,000 8,000 12,000 

Section 1254 IDCs 1,000 1,000 700 322 

Lease acquisition 1,000 700 1,000 

FIFO inventory 1,750 1,750 1,750 

LIFO inventory (excess 

over FIFO) 













The original cost of the assets was $23,750. After 3 years, their 
purchase price (and fair market value) is $23,825, while their tax 
basis has been reduced to $14,650. If the basis is stepped up, recap- 
ture tax of $2,505 must be paid. The net tax benefit of a step-up 


transaction (determined without regard to present value consider- 
ations), after payment of recapture tax, is $1,681 (assuming that no 
tax benefit is to be realized with respect to the inventory and disre- 
garding the effect on purchase price of the recapture tax liability). 
Because recapture tax generally is payable in the first year and the 
tax savings will occur over the remaining tax lives of the assets, 
present values must be considered. With the future cost of funds 
and yield on investments unknown, the parties should consider the 
transaction under a range of reasonable discount rates. At a 10-per- 
cent discount rate there would be a net loss of $143. At higher dis- 
count rates, the loss from a step-up transaction would be greater. 
No step-up election is indicated. (See Table 7.) 

Table 7.— Net Benefit of Step-Up 

Discount rate 






Net tax savings 






On the other hand, if the facts were changed so that the fair 
market value (and purchase price) of the assets created by the IDCs 
and the lease was increased to $4,000 each, a step-up election would 
be indicated under any reasonable discount rate. (See Table 8.) 

Table 8.— Net Benefit of Step-Up with Higher FMV 

Discount rate 






Net tax savings 






The parties may forego a step-up election even if the amount of 
projected tax savings indicates that a step up would be beneficial. 
There are a number of reasons for this. First, the acquiring corpo- 
ration may have borrowed substantial sums of money to make the 
acquisition. It may have difficulty raising affordable additional 
funds to pay the tax liability attributable to recapture. Second, the 
Internal Revenue Service, on audit, may challenge the claimed re- 
sults, particularly the taxpayer's claim as to the value of separate 
assets or their character as depreciable property. In few areas of 
the tax law is there more opportunity for controversy, especially if 
the acquired company was a large publicly-held company. As a 
result, there may be significant uncertainty as to the final costs 
and benefits. Third, no benefits will be available unless the acquir- 
ing corporation or its affiliated group has taxable income in the 
future against which to apply increased deductions resulting from 
the step up. An acquiring corporation that assumes without ques- 
tion that it will be able to use those benefits as they become avail- 
able will be taking some risk. 


(2) Preserving built-in losses 

If an acquired corporation's assets have an aggregate basis that 
is materially greater than their value, an acquiring corporation 
will wish to structure the acquisition so that the basis will carry 
over (rather than being stepped down to reflect the acquiring cor- 
poration's cost). Maintaining the high basis of low-value assets 
would permit the acquiring corporation to make use of the built-in 
losses against post-acquisition taxable income. The following exam- 
ple illustrates the manner in which an acquiring corporation could 
benefit from a built-in loss. 

Assume that the acquired corporation holds three types of prop- 

(1) Land with a value and basis of $1 million; 

(2) Equipment that is 5-year recovery property with a value 
of $2.5 million and an adjusted basis of approximately $5 mil- 
lion, which equipment is depreciated using a straight-line 
method over an optional recovery period of 12 years (resulting 
in an annual deduction of about $833,333); and 

(3) Section 1250 structures with a value and basis of $4 mil- 

The above example assumes that the remaining recovery period for 
the equipment is six years. 

Assuming that the acquired corporation has no liabilities, the ac- 
quiring corporation presumably will pay at least $7.5 million for 
the stock of the acquired corporation. The aggregate $10 million 
basis would survive. Section 269 could apply to disallow deprecia- 
tion deductions attributable to the $2.5 million built-in loss with re- 
spect to the equipment. See Treas. reg. sec. 1.269-3(c)(l) (to the 
effect that a corporation which acquires property with a built-in 
loss and utilizes the property to create tax-reducing deductions 
may be deemed to have had tax avoidance as its principal purpose). 
Nevertheless, the acquiring corporation may be able to utilize the 
built-in loss if it is able to establish that there are business reasons 
to rebut the presumption of a tax-avoidance motive. Because of the 
possible application of Section 269, and the resulting uncertainty 
regarding the acquiring corporation's ability to use the built-in 
loss, the existence of the loss may not have a significant effect on 
the purchase price. ^^ 

If the acquired corporation could be expected to generate 
$750,000 of pre-tax income in each of the next six years, and the 
built-in depreciation deductions are allowed in full, the deductions 
would yield a tax saving of approximately $345,000 each year (46 
percent of $750,000), resulting in an after-tax rate of return equal 
to the pre-tax rate of return of 10 percent. 

If the acquiring corporation had simply purchased the assets di- 
rectly, under the statutory table provided in section 168(b) the max- 
imum depreciation deduction that would have been available in the 
year of acquisition would be $375,000 (or 15 percent of the $2.5 mil- 
lion cost), rather than $833,333. Assuming the same 10-percent 
(pre-tax) rate of return, the acquiring corporation would pay tax on 

2 8 On the other hand, if the buyer is not worried about section 269, it should be willing to pay 
more than $7.5 million for the stock — $7.5 million for the assets and something more for the tax 
benefits that the built-in loss will provide. 


$375,000 ($750,000 of income less the $375,000 depreciation deduc- 
tion). Assuming a 46 percent tax rate, the after-tax return on a 
direct purchase would be only 7.7 percent ($750,000 less the tax of 

Because the acquired corporation's post-acquisition income in the 
example was insufficient to make full use of the built-in loss, the 
acquiring corporation may take steps to increase that income. For 
example, if the acquiring corporation is engaged in the same line of 
business as the acquired corporation, the acquiring corporation 
could divert business to its new subsidiary. Alternatively, the ac- 
quiring corporation could make a capital contribution of a profita- 
ble division to the acquired corporation. These steps could increase 
the after-tax rate of return above 10 percent. 

If the equipment had a value of $3.5 million, so that the aggre- 
gate value of the acquired corporations assets was equal to 85 per- 
cent of the aggregate basis, the acquired corporation could join in 
the filing of a consolidated return without running afoul of the 
SRLY rules. Thus, any depreciation deductions in excess of the ac- 
quired corporation's needs could be used to offset income generated 
by other members of the affiliated group. 

2. Tax-free reorganizations 

In general, to qualify an acquisitive transaction for tax-free 
treatment, the shareholders of the acquired corporation must 
retain "continuity of interest" in the combined enterprise. Thus, 
among other things, at least a principal part of the consideration 
used by the acquiring corporation must consist of stock. 

The definition of the term "reorganization" is found in section 
368(a). This provision lists four basic types of acquisitive reorgani- 
zations involving unrelated corporations: statutory mergers (or type 
"A" reorganizations); stock-for-stock exchanges (referred to as "B" 
reorganizations); transfers of substantially all of a corporation's 
assets for stock (a type "C" reorganization); and bankruptcy reorga- 
nizations (or type "G" reorganizations, which may be acquisitive or 
divisive in character). In addition to the statutory prescriptions, 
other rules apply including, for example, the "continuity of busi- 
ness enterprise" rule. See Treas. reg. sec. 1.368-l(d). A qualified re- 
organization generally results in the nonrecognition of gain or loss 
by the acquired corporation and its shareholders except to the 
extent that nonqualifying consideration (or "boot") is used. Fur- 
ther, the acquired corporation's basis for its assets and its tax his- 
tory carry over. 

a. Asset reorganizations 

Type A and Type C reorganizations are essentially asset acquisi- 
tions in which the acquired corporation goes out of existence. Com- 
pared to an A reorganization, the type of consideration that can be 
used in a C reorganization is limited. On the other hand, the ac- 
quiring corporation can pick and choose which liabilities it will 
assume in a C reorganization. In a type A reorganization, the ac- 
quiring corporation assumes all of the acquired corporation's liabil- 
ities by operation of law. 


Statutory mergers 

The type A reorganization is defined as a statutory merger or 
consolidation under state or Federal law (sec. 368(a)(1)(A)). The stat- 
ute does not prescribe the type of consideration that must be used 
in a statutory merger; however, the "continuity of interest" doc- 
trine requires that the consideration include a significant equity in- 
terest in the acquiring corporation. ^^ In the transaction, the ac- 
quired corporation merges into the acquiring corporation, and the 
merged corporation's shareholders exchange their stock for consid- 
eration provided by the acquiring corporation. There are no ex- 
press limits on the ability of the acquired corporation to dispose of 
unwanted assets before the merger. 

"Forward" subsidiary merger. — The definition of an A reorgani- 
zation also includes a "forward" subsidiary merger, in which the 
acquired corporation merges into a subsidiary of the corporation 
that provides the stock used as consideration in the merger (sec. 
368(a)(2)(D)). To qualify a forward subsidiary merger as a type A re- 
organization, substantially all of the merged corporation's assets 
must be acquired. Thus, pre-merger dispositions by the acquired 
corporation are limited. Under Internal Revenue Service ruling 
guidelines, generally the "substantially all test" is satisfied if the 
transferred assets constitute 90 percent of the value of the net 
assets, and 70 percent of the value of the gross assets, held by the 
acquired corporation immediately before the transfer. Rev. Proc. 
77-37, 1977-2 C.B. 568. 

"Reverse" subsidiary mergers. — In a "reverse" subsidiary merger, 
a subsidiary of the acquiring corporation merges into the acquired 
corporation, with the acquired corporation surviving the merger 
(sec. 368(a)(2)(E)). Although this transaction is similar to a type B 
reorganization (described below), it is included in the definition of a 
statutory merger. The surviving corporation must hold substantial- 
ly all of the properties of both corporations after the transaction. 
Also, in the merger, shareholders must transfer stock representing 
"control" of the acquired corporation in exchange for voting stock 
of the acquiring corporation. For this purpose, control is defined as 
ownership of at least 80 percent of the voting stock, and at least 80 
percent of every other class of stock, of the acquired company (sec. 

Type C reorganizations 

A type C reorganization is an acquisition of substantially all of a 
corporation's assets "solely" in exchange for voting stock of the ac- 
quiring corporation (or of a corporation in control of the acquiring 
corporation) (sec. 368(a)(1)(C)). In determining whether qualified 
consideration is used, the acquiring corporation's assumption of a 
liability is disregarded. Under the "boot relaxation rule" of section 
368(a)(2)(B), up to 20 percent of the consideration can consist of 
property other than stock of a party to the reorganization, al- 

29 Compare John A. Nelson v. Helvering, 296 U.S. 374 (1935) (where 38 percent of the consider- 
ation consisted of nonvoting preferred stock and 62 percent of cash, the requirement was satis- 
fied), with Pinellas Ice & Cold Storage Co. v. Commissioner, 287 U.S. 462 (1933) (short-term notes 
did not provide sufficient continuity). 


though the 20-percent Umitation is reduced by the amount of liabil- 
ities assumed by the acquiring corporation. 

The type C reorganization provisions are intended to apply to 
transactions that are functionally equivalent to statutory mergers. 
In a statutory merger, the acquired corporation is liquidated by op- 
eration of law. Thus, the statute requires the complete liquidation 
of a corporation whose assets are acquired in a C reorganization, 
unless this requirement is waived by regulations. Even if the liqui- 
dation requirement is waived, however, the transaction is treated 
as if a complete liquidation had occurred. 

b. Stock reorganizations 

A type B reorganization is an acquisition of stock representing 
control of the acquired corporation solely in exchange for voting 
stock of the acquiring corporation (or a corporation in control of 
the acquiring corporation) (sec. 368(a)(1)(B)). Unlike the reverse sub- 
sidiary merger, where the acquiring corporation must obtain con- 
trol in the transaction, a B reorganization can be accomplished by 
a "creeping acquisition" of the acquired corporation's stock. 

c. Bankruptcy reorganizations 

A type G reorganization is defined as a transfer c f part or all of 
a corporation's assets to another corporation in a title 11 or similar 
bankruptcy proceeding if stock or securities of the transferee are 
distributed in a transaction that qualifies under section 354, 355, or 
356 (sec. 368(a)(1)(G)). To facilitate insolvency reorganizations, the 
continuity of interest doctrine (described above) is generally ap- 
plied by reference to the continuing interests of creditors of the 
debtor (acquired) corporation. 

d. Treatment of parties to a reorganization 
Acquired corporation 

A corporation does not recognize gain or loss on the transfer of 
its property for stock or securities of a corporation that is a party 
to the reorganization (sec. 361(a)). If the acquired corporation also 
receives nonqualifying consideration, then gain (but not loss) is rec- 
ognized unless the boot is distributed pursuant to the plan of reor- 
ganization (sec. 361(b)). In general, the acquiring corporation's as- 
sumption of the acquired corporation's liabilities is not treated as 

Shareholders and security holders 

Generally, no gain or loss is recognized by shareholders or securi- 
ty holders who exchange stock or securities solely for stock or secu- 
rities in a corporation that is a party to the reorganization (sec. 
354(a)). If the exchange also involves the receipt of nonqualifying 
consideration, gain (but not loss) is recognized up to the amount of 
the boot. Further, part or all of that gain may be taxed as a divi- 
dend (at ordinary income rates) if the exchange has the effect of a 
dividend. In general, a shareholder or security holder is treated as 
receiving boot if the principal amount of securities received exceeds 
the principal amount of securities surrendered, if securities are re- 


ceived and no securities are surrendered, or if property other than 
stock of a corporate party to the reorganization is received. 

If the exchanging shareholder or security holder receives only 
qualified consideration, the exchanging taxpayer takes a basis in 
the qualified consideration that is equal to the basis of the stock or 
securities surrendered in the exchange (sec. 358(a)). Thus, recogni- 
tion of gain is deferred until a subsequent disposition of the stock 
or securities received. (The original appreciation in the acquired 
corporation's stock can escape taxation entirely if the shareholder 
holds the qualified consideration until death. In that case, the basis 
of the stock or securities in the hands of the taxpayer's estate will 
be stepped up to its fair market value.) Security holders are taxed 
on the receipt of qualified consideration attributable to accrued in- 
terest on securities surrendered (sec. 354(a)(2)). 

Boot dividends. — The determination of whether the receipt of 
boot has the effect of a dividend is generally made by reference to 
the principles of section 302 (which provides rules for distinguish- 
ing ordinary dividend distributions from capital gain redemptions). 
Under section 302, a distribution is generally treated as a dividend 
if the distribution does not effect a significant change in the share- 
holder's interest in the distributing corporation. ^° In the case of an 
ordinary distribution, the amount is taxed as a dividend to the 
extent of available (current or accumulated) earnings and profits. 
Under section 356, however, a boot dividend is taxed at ordinary 
income rates only to the extent of the lesser of the shareholder's (1) 
gain or (2) ratable share of accumulated earnings and profits. 
Where a taxpayer receives boot, the basis of the boot is equal to its 
fair market value, and the taxpayer's basis in qualified consider- 
ation is decreased by the value of the boot and increased by the 
amount of any recognized gain (or dividend). 

Acquiring corporation 

Section 1032 provides nonrecognition treatment to an acquiring 
corporation that issues its stock to acquire property, even if the is- 
suance is not part of a tax-free reorganization. Similar treatment 
generally is provided if a subsidiary corporation issues its parent's 
stock in a qualifying reorganization. See Rev. Rul. 57-278, 1957-1 
C.B. 124. See also, Treas. prop. regs. sec. 1.1032-2. The acquiring 
corporation generally takes a carryover basis for assets or stock re- 
ceived in connection with a reorganization, increased by any gain 
recognized to the transferor on the transfer (sec. 362(b)). In addi- 
tion, the acquiring corporation in an asset reorganization "steps 
into the shoes of the acquired corporation with respect to earnings 
and profits, NOL carryovers, and other tax attributes (sec. 381). 
The special limitations on the use of NOL carryovers do not come 
into play unless the equity interest received or retained by a loss 
corporation's shareholders is less than 20 percent of the acquiring 
corporation's outstanding stock (sec. 382(b)). However, section 269 
could apply to disallow NOL deductions if the principal purpose of 

30 Compare Wright v. United States, 482 F.2d 600 (8th Cir. 1973) (dividend equivalency was 
measured by shareholders' continuing interests in the surviving corporation after a consolida- 
tion of 2 related corporations), with Shimberg v. United States, 577 F.2d 283 (5th Cir. 1978) 
(where, following a merger, the court tested d>vid«»d equivalency by assuming a hypothetical 
redemption by the acquired corpwation before the merger). 


the acquisition was tax avoidance. If the acquired corporation re- 
mains in existence (as in a type B reorganization), it can join in the 
fiHng of a consolidated return (as described above in the descrip- 
tion of taxable acquisitions), although the SRLY rules (including 
those rules insofar as they relate to built-in losses) would apply. 


(1) Utilization of acquired corporation's NOL carryovers 

The acquiring corporation may structure an acquisition as a tax- 
free reorganization to preserve the acquired corporation's tax histo- 
ry without maintaining the acquired corporation as a separate 
entity. The following example illustrates the application of the 
rules that permit an acquiring corporation to utilize the NOL car- 
ryovers of an acquired corporation. 

Assume that the acquiring corporation projects that it will have 
annual taxable income of $1 million for each of the next 5 years. 
Also assume that the acquired corporation has NOL carryovers of 
$20 million and that none of the carryovers will expire before the 
end of 5 years. The acquired corporation also has assets used in its 
trade or business, but these assets are not expected to generate tax- 
able income. 

If the acquired corporation is merged into the acquiring corpora- 
tion under section 368(a)(1)(A), the $20 million NOL carryover will 
survive and be inherited by the acquirer (sec. 381). Assuming that 
the acquired corporation's shareholders receive only 5 percent of 
the acquiring corporation's outstanding stock, the present-law spe- 
cial limitations would disallow 75 percent (or $15 million) of the 
NOL carryover (sec. 382(b)). Even so, the $5 million carryover that 
remains available would be sufficient to cover the acquiring corpo- 
ration's earnings over the next 5 years. The stock used as consider- 
ation could be nonvoting preferred stock, giving the acquired corpo- 
ration's shareholders only a limited interest in the acquiring corpo- 

Assuming that the acquiring corporation is taxable at a 46-per- 
cent marginal rate (and, so, would have paid about $460,000 in tax 
for each of the 5 years in question), the use of the acquired corpora- 
tion's NOL carryover would yield tax savings of $2.3 million. Of 
course, the present value of the tax savings would be somewhat 
less than $2.3 million, depending on the discount rate used. 

The special limitations on the use of NOL carryovers following a 
reorganization (rather than a taxable purchase) do not require that 
the acquiring corporation continue the acquired corporation's busi- 
ness, although the continuity of business enterprise doctrine may 
limit the acquiring corporation's ability to simply dispose of the ac- 
quired corporation's unwanted assets. In addition, section 269 may 
be implicated if the acquiring corporation discontinues the ac- 
quired corporation's business. See Treas. regs. sec. 1.269-6 (example 
(1)). Alternatively, the acquiring corporation might choose to con- 
tinue the acquired corporation's uneconomic business, to head off 
assertions that the acquisition was tax-motivated. In any event, be- 
cause of the possible application of section 269, the value of the 
NOL carryover may be discounted for purposes of setting the value 


of the consideration paid to the acquired corporation's sharehold- 

(2) Acquisitions by corporations with NOL carryovers 

Instead of seUing a corporation with large NOL carryovers, the 
loss corporation's shareholders may decide to cause it to acquire 
another profitable corporation in a tax-free reorganization to make 
use of its own carryovers. The special limitations on the use of 
NOL carryovers generally would not apply if the loss corporation's 
shareholders retained at least 20 percent of the combined enter- 

B. Financing Aspects of Acquisitions 

1. In general 

Although a corporation could be acquired solely for cash that has 
been accumulated, after taxes, by the acquirer, virtually all merg- 
ers and acquisitions involve some — often a sul3stantial — degree of 
financing. Financing may take the form of either equity (common 
or preferred stock) or debt. The tax consequences to the parties to a 
corporate merger or acquisition and their shareholders vary de- 
pending on whether debt or equity financing is used. As discussed 
below, the tax law contains a strong bias in favor of debt financing. 
Many recent acquisitions have been accomplished using a high 
degree of leverage. 

a. Equity financing 

As discussed above, if the acquirer is a corporation, it may issue 
its own stock in exchange for target stock or target assets. Alterna- 
tively, the acquiring corporation might obtain funds by selling its 
own stock in the market and then using the proceeds to acquire 
the stock or assets of the target. 

If the merger or acquisition is accomplished through the issuance 
of stock of the acquiring corporation, the transaction will be tax- 
free to that corporation (sec. 1032) and may be tax-free to the 
target corporation's shareholders and the target corporation if cer- 
tain requirements are met. If the transaction involves an exchange 
of stock or securities by the shareholders of the target corporation, 
and the exchange fails to qualify under the reorganization provi- 
sions of the Code, each shareholder of the target corporation will 
recognize gain to the extent the value of the stock or securities re- 
ceived exceeds the shareholder's basis in the stock or securities sur- 
rendered. Generally, the entire amount of any gain will be recog- 
nized in the year of the sale.^^ 

Distributions by the acquiring corporation with respect to stock 
issued to finance an acquisition, whether to the former sharehold- 
ers of the target corporation or to the general public, generally will 
not be deductible by the acquiring corporation. Moreover, these dis- 
tributions will generate ordinary dividend income to individual 

^ ' Similar consequences would generally follow from a nonqualifying exchange of assets by 
the target corporation for stock of the acquiring corporation. In certain circumstances, however, 
section 337 might permit nonrecognition of gain at the corpwrate level. 

3^ Footnote eliminated. 


shareholders to the extent of the issuing corporation's earnings and 
profits. Thus, the income reflected by these distributions generally 
will be subject to double taxation. Finally, in certain circum- 
stances, payments received by the shareholders in redemption of 
their stock may be treated as dividend income rather than as pro- 
ceeds from the sale or exchange of the stock. 

One common nontax consequence of using equity rather than 
debt financing is that interests of the pre-acquisition stockholders 
of the acquiring corporation are diluted by the issuance of addition- 
al shares of stock. 

b. Debt financing 

An acquirer may purchase the target corporation's stock or 
assets using funds borrowed from domestic or foreign banks or 
other financial institutions, or from individual or corporate inves- 
tors (e.g., pension funds or insurance companies). A corporate ac- 
quirer could also borrow from the target corporation or its share- 
holders by issuing its own debt obligations to the target or its 
shareholders in exchange for assets or stock. The stock or assets 
purchased with the proceeds of the debt may be pledged as security 
for the loan. 

Subject to certain limitations,^^ interest paid or accrued on a 
loan is deductible by the borrower for tax purposes (sec. 163). Al- 
though payments of interest are in theory ordinary income to the 
lender, all repayments of loan principle are tax-free. ^^ (Of course, 
repayments of principle will result in some taxation of the lender if 
the loan was part of an installment sale under section 453.) 

Financing an acquisition using corporate debt does not directly 
affect the equity of the shareholders of an acquiring corporation. 
However, as discussed in parts two and three, the use of debt fi- 
nancing can reduce significantly the after-tax cost of an acquisi- 
tion. This follows from the simple rule that the issuer of debt can 
deduct the amount it pays for the use of the borrowed funds (inter- 
est), while the issuer of stock cannot deduct the amount it pays to 
those providing the capital for the use of that capital (dividends). ^^ 

^^ In limited circumstances, section 279 denies a deduction for interest on corporate acquisi- 
tion indebtedness. The limitation applies to interest in excess of $5 million per year incurred by 
a corporation with respect to debt obligations issued to provide consideration for the acquisition 
of the stock, or two-thirds of the assets of, another corporation, if each of the following condi- 
tions exists: (1) the debt is substantially subordinated; (2) the debt carries an equity participation 
(for example, includes warrants to purchase stock of the issuer or is convertible into stock of the 
issuer); and (3) the issuer is thinly capitalized (i.e., has an excessive debt-to-equity ratio) or pro- 
jected annual earnings do not exceed three times annual interest costs. 

^•^ By contrast, as noted above, payments in redemption of corporate stock may be treated as 
dividends (ordinary income) rather than as proceeds from a sale (which would permit the recipi- 
ent a tax-free recovery of its basis in the stock). 

'* Some corporations which have sufficient earnings to pay dividends under applicable state 
corporate law for one reason or another may not have taxable income for Federal income tax 
purposes. These corporations would receive no current tax benefit from interest deductions. In- 
stead of issuing debt obligations, therefore, they may issue preferred stock with substantial debt- 
like characteristics. Because of the 85 percent dividends received deduction, the preferred stock 
would likely be acquired by taxpaying corporations. The result is that the tax benefits of the 
financing (i.e., deductions for financing costs) are in part passed on to the holder of the preferred 
stock, which can better use them. However, as a result of the 1984 Act, if a corporation borrows 
the funds used to purchase dividend-paying stock, the dividends received deduction may be re- 
duced in certain situations (sec. 246A). The amount of the reduction is determined by the degree 
of leverage involved. 


2. Specific provisions affecting debt-financed acquisitions 

a. Cost recovery allowances and installment reporting 

The Accelerated Cost Recovery System (ACRS) generally permits 
the cost of depreciable assets acquired after 1980 to be recovered on 
a much more accelerated basis than assets acquired in previous 
years. The deductions allowed under ACRS in early periods of use 
of an asset are often very large when compared to the actual eco- 
nomic deterioration of the asset. 

In some cases, the tax benefits resulting from ACRS may provide 
a target corporation with significant liquid assets, thus increasing 
its attractiveness as a takeover candidate. In addition, similar ben- 
efits may provide a large portion of the debt service costs incurred 
in financing an acquisition (or internally-generated cash used in 
the acquisition). For example, the large deductions available under 
ACRS in the early years following acquisition may offset income of 
the acquirer (in the case of an asset purchase) or of the target cor- 
poration (in the case of a stock purchase followed by a section 338 
election), thus reducing tax liability. These tax savings are the 
equivalent of cash payments to a taxpayer. 

The basis of the acquired assets for depreciation purposes is the 
cost of the assets or, where a section 338 election is made, the cost 
(with adjustments) of the target stock. Under long-established prin- 
ciples of tax law, the cost of an asset includes not only cash paid 
but the principal amount of any purchase-money debt.^^ This debt 
may be represented by an installment note, in which case the ag- 
gregate tax benefits available to the parties may be magnified even 
further. Under section 453, gain on an installment sale may be de- 
ferred and recognized by the seller as payments of principle are re- 
ceived if, among other things, the installment obligation received is 
not payable on demand or readily tradable. Thus, while the seller 
recognizes gain on a deferred basis (which gain generally is treated 
as capital gains), the purchaser immediately receives a cost basis 
which includes the full principal amount of the note. If a target's 
assets have been purchased (or its stock purchased and a section 
338 election made), some or all of that cost may be allocable to de- 
preciable assets. 

Because the sales proceeds realized by a seller in an installment 
sale qualifying under section 453 are not reduced in the year of 
sale by taxes, the seller can realize a higher after-tax return on the 
proceeds than if the installment method were not used. Further- 
more, under present law, the seller may be able to raise cash by 
borrowing against the installment obligation without triggering 
any tax consequences. If so, the primary reason for permitting sec- 
tion 453 to apply — that the seller has no cash with which to pay 
current taxes — disappears. 


Assume that on January 1, 1986, P Corporation purchases all of 
the stock of T Corporation from T's sole shareholder, A. As consid- 
eration for the stock, P gives A its non-readily tradable term in- 

^^ The principal amount may be adjusted downward if the debt instrument bears inadequate 
interest (see sees. 483 and 1274). 


stallment note with a face amount and a fair market value of $1 
million. The note bears interest at an annual rate of 13 percent, ^"^ 
payable annually in arrears. The principal amount is payable in a 
lump sum on December 31, 1995. A's adjusted basis in his stock is 
$200,000, as is T's basis in its assets. 

If A does not elect out of the installment method, under section 
453 he will recognize no gain in the year of sale. He will report 
$130,000 of ordinary interest income in each of the 10 years the 
note is outstanding and will recognize $800,000 of capital gain 
income in the year the note matures (1995). The tax at that time 
will be $160,000. 

By contrast, if A had received $1 million in cash or marketable 
securities in lieu of the installment note (and therefore would have 
been ineligible for installment reporting), he would have recognized 
$800,000 of capital gain income in 1986, would have paid $160,000 
in taxes in that year, and would have had only $840,000 in pro- 
ceeds left to reinvest. Assuming he could have invested the pro- 
ceeds at the same pre-tax rate of return he earned on P's install- 
ment note (13 percent), his annual income from the reinvestment 
would be only $109,200 (leaving as little as $54,600 after taxes), 
compared to $130,000 (as little as $65,000 after taxes) if the install- 
ment method case. 

Even if A uses the installment method and recognizes no gain on 
the sale until 1995, if P makes a section 338 election T will be enti- 
tled to an immediate stepup in basis in its assets. T's new basis will 
be based on $1 million, the purchase price of the T stock. To the 
extent T's assets are depreciable, T can immediately begin to take 
depreciation deductions using a $1 million basis rather than a 
$200,000 basis. Furthermore, P will be deducting $130,000 each 
year as interest expense. These deductions could be used by P to 
offset T's income or P's income. 

b. Provisions relating to qualified pension plans 

Overfunded pension plans 

If a pension, profit-sharing, or stock bonus plan qualifies under 
the tax laws ("qualified pension plan"), a trust holding the plan's 
assets generally is exempt from Federal income tax. Furthermore, 
contributions to a qualified pension plan by an employer are de- 
ductible, within specified limits, in the year for which the contribu- 
tions are made. The participants in the plan, however, are not 
taxed on plan benefits until the benefits are distributed. 

Under a defined benefit pension plan,^® minimum funding rules 
apply that require an employer to make contributions to the plan 
so that an employee's retirement benefit will be fully funded upon 
his retirement. Under certain of the permissible funding methods, 
an employer's funding costs are levelled over an employee's work- 
ing years even though the costs of benefits earned normally in- 
crease as the employee approaches retirement age. Thus, at any 

^' Assume that this rate is adequate for purposes of section 1274. 

^* A defined benefit pension plan is a plan under which an employee accrues ("earns") a spec- 
ified retirement benefit that is not related to the amount of assets held by the plan or any ac- 
count balance maintained for the employee. 


time, the plan may have assets that exceed the present value of the 
liabilities to employees for previously accrued benefits. 

In addition, in recent years, high interest rates have contributed 
to substantial increases in the value of the assets held in many 
trusts under qualified pension plans. Although these increases in 
value must be amortized over 15 years in calculating the employ- 
er's minimum funding costs, one effect may be that a plan's assets 
may be substantially greater than its liabilities prior to the time 
the amortization period has expired. 

If a qualified pension plan is terminated, the rights of employees 
to benefits accrued up to the date of the plan termination must be 
nonforfeitable. Although a qualified pension plan must be estab- 
lished for the exclusive benefit of employees, present law provides 
that an employer is entitled to recoup excess assets on plan termi- 
nation to the extent the plan has assets remaining after all obliga- 
tions to employees have been satisfied (i.e., to the extent that the 
plan is overfunded). If the excess assets represent amounts previ- 
ously deducted by the employer or earnings on those amounts, the 
employer is required to include the recouped amounts in gross 
income for the year in which the amounts are received. Other de- 
ductions or credits (including loss carryovers) that the employer is 
entitled to claim may be used to offset the tax on this income. 

An overfunded pension plan represents a pool of assets that may 
make a company a target for a takeover. Conversely, this pool of 
assets may be used by the company to ward off a hostile takeover. 
In recent years, some companies with significantly overfunded pen- 
sion plans have been acquired by other companies. After the acqui- 
sition, the acquiring company terminated the overfunded pension 
plan and used the excess assets partially to finance the takeover. It 
is possible that the target companies failed to take account of the 
value of assets in the qualified pension plan in setting a purchase 

It has been suggested that, as companies become more familiar 
with the existence of excess assets in their pension plans, the role 
of overfunded pension plans for an acquiring company will be di- 
minished. On the other hand, it has been argued that an overfund- 
ed plan represents an attractive source of cash even if the value of 
the assets are included in the purchase price. Under the latter 
analysis, companies with overfunded pension plans will continue to 
be attractive takeover targets. 

Another possibility is that a company will itself terminate an 
overfunded pension plan to bankroll efforts to thwart a hostile 
takeover attempt. This can be accomplished in one of two ways. 
First, the company can invest the excess assets in plant and equip- 
ment, thus making itself less attractive than if it held a large 
amount of liquid assets. Alternatively, the company can establish 
an employee stock ownership plan (ESOP) funded with the excess 

Employee stock ownership plans 

An ESOP is a part of a stock bonus or money purchase pension 
plan that invests primarily in the securities of the employer. 
ESOPs are accorded preferential tax treatment under the Code as 
an incentive to participation by employees in their employer. Thus, 


ESOPs are exempt from tax under the rules generally applicable to 
qualified pension plans, and, subject to statutory limitations, em- 
ployer contributions to an ESOP are tax-deductible. 

An ESOP that borrows funds to purchase employer securities is 
referred to as a "leveraged ESOP." An employer may deduct the 
full amount of any contribution to a leveraged ESOP that is used 
by the ESOP to pay interest on a loan to purchase employer securi- 
ties and may deduct amounts used to repay loan principle up to 25 
percent of payroll costs. 

The Deficit Reduction Act of 1984 added additional tax incentives 
to the establishment and use of ESOPs, including the following: 

(1) A taxpayer owning qualified securities in an employer corpo- 
ration may defer recognition of gain on the sale of the securities to 
an ESOP that holds at least 30 percent of the employer's securities, 
to the extent the taxpayer reinvests the proceeds in securities of 
certain domestic corporations. 

(2) A corporate employer may deduct dividends paid on employer 
stock held by an ESOP and allocated to participants' accounts if 
the dividends are paid currently to employees. 

(3) A bank, insurance company, or corporation actively engaged 
in the business of lending money may exclude from its gross 
income 50 percent of the interest received with respect to any loan 
the proceeds of which are used by an ESOP to purchase employer 

A leveraged ESOP can be used by an employer as a financing 
tool to obtain funds for working capital, plant expansion, or other 
purposes. Often this funding method results in a much lower cost 
of borrowing than would be available if conventional debt or equity 
financing were used. In a typical transaction, the employer enters 
into a contract with the ESOP to sell the ESOP a specified number 
of shares of its stock. The ESOP borrows the funds needed to pur- 
chase the shares from a bank or other lender and pays them over 
to the employer in exchange for the stock. ^^ In subsequent years, 
the employer makes tax-deductible cash contributions to the ESOP 
in the amount necessary to amortize the loan principal and make 
interest payments thereon. *° 

A leveraged ESOP may be used not only to provide the company 
with working capital but also to finance an acquisition of the stock 
or assets of another corporation. In a typical case, a leveraged 
ESOP maintained by the acquiring corporation or its subsidiary 
borrows funds in an amount equal to the amount needed to acquire 
the target corporation. The proceeds of the loan are used to pur- 
chase employer securities. The employer (or the subsidiary) then 
uses the proceeds of the sale to purchase the stock or assets of the 
target company. Again, the employer's contributions to the lever- 
aged ESOP to enable it to amortize the loan will be deductible. In 

^^ The lender usually requires either that the employer guarantee the loan or that the stock 
purchased with the loan proceeds be pledged as collateral. Because of the 50-percent interest 
exclusion available to the lender, it may be able to lend to the ESOP at a lower rate — as low as 
80 percent of the existing prime rate — than it lends to its regular customers. 

^° Alternatively, the employer may take out the loan itself and sell its stock to the ESOP in 
exchange for the ESOP's installment note. The employer will make (deductible) contributions to 
the ESOP in future years that will enable the ESOP to pay off the note. These payments will be 
used by the employer to repay its lender. 


this manner, the corporation will have significantly reduced its 
after-tax cost of financing the acquisition. 

One variation of this leveraged-ESOP financing technique is for 
the employer to purchase target stock, either directly or through a 
subsidiary, using funds borrowed from a financial institution or 
other lender. Once the acquisition has been completed, the newly- 
acquired subsidiary establishes a leveraged ESOP. The ESOP bor- 
rows money and purchases stock in the subsidiary from the subsidi- 
ary (or from the acquiring corporation). The acquiring corporation 
then uses the proceeds of this sale to pay off the original acquisi- 
tion loan. The subsidiary makes annual, deductible contributions 
sufficient to amortize the ESOP loan and pay interest. "^^ 

Recently, leveraged ESOPs have been used in some situations to 
thwart hostile corporate takeover attempts. By selling stock to an 
ESOP, a company may make it difficult for a hostile bidder to ac- 
quire control, since stock held by an ESOP generally can be expect- 
ed to be voted to keep the company independent. Proceeds of the 
sale are generally available for any purpose, including the payment 
of greenmail. Moreover, a sale of stock to the ESOP will not neces- 
sarily dilute management's control of the company to the same 
degree as a sale to outside parties. The stock purchased by an 
ESOP is not immediately credited to employees' individual ac- 
counts but is held in a suspense account and released for allocation 
to employee accounts only as the loan is repaid with employer con- 
tributions. During this period, the shares may be voted by plan 
trustees appointed by management. Furthermore, in some cases 
the shares sold to the ESOP have more limited voting rights than 
are normally granted to shareholders of public companies. Thus, 
the employees' ability to control policy and management decisions 
may be limited. 

Leveraged ESOPs have also been used to accomplish leveraged 
buy-outs by company managers desiring to "take the company pri- 
vate", that is, to remove it from public ownership. 

An incidental effect of leveraged ESOP financing of an acquisi- 
tion is that the equity interests of the employer's pre-acquisition 
shareholders may be diluted. This dilution may occur as well, how- 
ever, in any equity financing arrangement, including a merger 
with another corporation in which stock of the surviving corpora- 
tion is issued to the former shareholders of the target. 

Other issues relating to qualified pension plans 

In addition to the potential use of qualified pension plans (includ- 
ing ESOPs) as financing tools in mergers and acquisitions, other 
issues are presented when companies, who maintain qualified pen- 
sion plans, merge. These issues depend, in part, upon whether the 
successor company continues to maintain any of the qualified pen- 

■" If the management and shareholders of the target company cooperate in the acquisition, it 
is possible that a portion of the proceeds of the sale of target stock by original target sharehold- 
ers would qualify for tax-free rollover under section 1042. Thus, the acquiring corporation and 
the target shareholders could agree in advance that a portion (enough to qualify the ESOP as a 
30-percent shareholder) of their shares would be purchased by a leveraged ESOP established by 
the target and the balance by the acquiring corporation. The proceeds of the sale to the ESOP 
might qualify for tax-free reinvestment under section 1042. 


sion plans of the predecessor company. A full analysis of these 
issues is beyond the scope of this pamphlet. 

c. Provisions relating to international taxation 

Interest and dividends paid to foreign lenders and shareholders 

In general, U.S. source dividends and (prior to the 1984 Act) in- 
terest paid to a nonresident alien individual or foreign corporation 
that are not ''effectively connected" with the conduct of a U.S. 
trade or business of the individual or corporation are subject to tax 
at a flat rate of 30 percent (sees. 871 and 881). The payor is obligat- 
ed to withhold the appropriate amount of tax (sees. 1441, 1442). In- 
terest and dividends paid by a U.S. corporation on its debt obliga- 
tions are generally treated as U.S. source income. 

In many cases, the interest withholding tax imposed by sections 
871 and 881 of the Code is reduced or eliminated by the provisions 
of an income tax treaty between the United States and the country 
in which the recipient resides. Furthermore, under the 1984 Act, 
interest paid to certain foreign persons with respect to certain port- 
folio debt investments is wholly exempt from U.S. tax. Accordingly, 
interest that is fully deductible by a U.S. corporate payor may be 
received wholly free of U.S. taxation by the foreign lender. 

U.S. source dividends, although not deductible by the U.S. payor, 
may also be subject to a reduced withholding tax pursuant to a 
treaty between the United States and the shareholder's country of 

Sourcing of interest expense 

A U.S. taxpayer may generally claim a credit against its U.S. tax 
for income taxes paid to a foreign government. In order to prevent 
foreign taxes from offsetting taxes on U.S. source income, however, 
the Code limits the credit to the amount of U.S. tax that would 
have been payable on the foreign income. The maximum foreign 
tax credit available to a taxpayer in a particular year is the 
amount of the foreign tax multiplied by a fraction the numerator 
of which is the taxpayer's foreign source taxable income and the 
denominator of which is its worldwide taxable income. Thus, a cor- 
poration increases its limiting fraction, and hence its usable foreign 
tax credit, to the extent it can treat income as foreign source 
income. The same result is achieved when an expense is treated as 
U.S. rather than foreign source. 

A multinational corporation (one with significant foreign as well 
as domestic assets and earnings) seeking to acquire a domestic cor- 
poration using borrowed funds may not be able to increase the util- 
ity of the foreign tax credit by virtue of the borrowing. Treasury 
regulations require that a taxpayer's interest expense be allocated 
between U.S. and foreign source income based on the relative value 
of the taxpayer's assets. Thus, the multinational's foreign assets 
would normally attract a portion of the interest on the acquisition 

The sourcing rules under present law, however, provide ample 
opportunity for manipulation by a corporation seeking to maximize 
its foreign tax credit utility. To avoid having the interest expense 
on acquisition indebtedness reduce its foreign source income and 


hence the foreign tax credit Hmitation, the corporation may have 
the acquisition indebtedness incurred by a related corporation {e.g., 
a parent holding company) whose income is entirely derived from 
U.S. sources. In this manner, the interest expense would not affect 
the corporation's foreign tax credit, but, as a member of the par- 
ent's affiliated group, the corporation would nonetheless receive 
the benefits of the acquisition indirectly. 

d. Provisions relating to partnerships 

The tax law permits a partnership to flow through to its partners 
items of deduction and loss paid or incurred by the partnership. In 
some cases, general or limited partnerships have been used to ac- 
quire the stock (or assets) of a target corporation, using both funds 
borrowed by the partnership from institutional lenders and funds 
contributed as equity by the partners. Any interest paid on the ac- 
quisition indebtedness is deductible by the partners, generally on a 
pro rata basis although special allocations may be possible. 

In these situations, no dividends received deduction is available 
to a partnership or its individual partners with respect to dividends 
received from the target corporation. However, to the extent the 
partners are not corporations, dividends received will not trigger 
the extra 6.9 percent tax imposed on most intercorporate distribu- 
tions. Furthermore, the partnership may end up owning and oper- 
ating the business of the target corporation directly, including after 
a section 337 or section 338 transaction. In such a case, tax benefits 
generated by the business will pass through directly to the partner- 
ship's partners, again, generally on a pro rata basis although spe- 
cial allocations may be possible. 

The partnership provisions may also permit an acquired corpora- 
tion to shelter taxable income with loss carryovers of an unrelated 
corporation, thus making it easier for any money borrowed in con- 
nection with the acquisition to be paid off with pre-tax dollars. 

In addition, certain nontax considerations (e.g., securities laws) 
may make a partnership preferable to a corporation as an acquisi- 
tion vehicle. 

C. Golden Parachutes 

Corporations are generally permitted a deduction for all the ordi- 
nary and necessary expenses paid or incurred during the taxable 
year in carrying on a trade or business. Generally, reasonable com- 
pensation for salaries or other compensation for personal services 
actually rendered qualifies as ordinary and necessary expenses. In 
recent years, many corporations have entered into arrangements, 
commonly called "golden parachutes", to provide substantial pay- 
ments to top executives and other key personnel of the corporation 
in connection with any acquisition that might occur. 

Golden parachutes are designed in part to dissuade an interested 
buyer, by increasing the cost of the acquisition, from attempting to 
proceed with an acquisition. If the takeover does not occur, the tar- 
get's executives and other key personnel would more likely retain 
their positions, so the golden parachute could effect the preserva- 
tion of the jobs of such personnel. Where no takeover had yet com- 
menced but the corporation viewed itself as an unwilling potential 


target, golden parachutes were often entered into to discourage po- 
tential buyers from becoming interested. 

Sometimes, an acquiring corporation will enter into long-term 
employment contracts or similar arrangements with key personnel 
of the acquired corporation. These arrangements can remove the 
incentive for such personnel to examine a proposed takeover care- 

The 1984 Act imposed significant tax burdens on the use of cer- 
tain kinds of arrangements of a type described. Under the 1984 Tax 
Act, no deduction is allowed for "excess parachute payments." Fur- 
ther, if any such payment is made by the acquiring company, or a 
shareholder of the acquired or the acquiring company, it will not 
be treated as part of the acquiring company's purchase price for 
the acquired company, or as increasing the shareholder's basis in 
his stock in the acquired or acquiring company. Finally, a nonde- 
ductible 20-percent excise tax is imposed on the recipient of any 
excess parachute payment. 


Some of the Federal income tax rules described above may be re- 
sponsible, in whole or in part, for the recent surge in merger and 
acquisition, and attempted merger and acquisition, activity. The 
following changes, among others, in the applicable tax rules might 
be considered. Several of the suggestions (e.g., those relating to in- 
stallment sales) would have ramifications well beyond the merger 
and acquisition area and would need to be considered in that light. 
Other of the suggestions are more limited. 

Mandatory asset acquisition 

In many respects, the taxable acquisition of a substantial, con- 
trolling stock interest in an acquired corporation is the acquisition 
of the assets of that corporation. The acquiring corporation indi- 
rectly gains control of those assets, and it may obtain direct control 
of them. 

One possible change would be to require the acquisition of a con- 
trolling stock interest in a corporation in a taxable transaction to 
be treated as an acquisition of the assets of the acquired corpora- 
tion rather than as an acquisition of its stock. One result would be 
to require the acquired corporation to recognize gain (or loss) with 
respect to its assets. This required recognition might be limited to 
present-law recapture items or it might be expanded (in which case 
a change in the rules relating to liquidating sales of assets and in- 
kind liquidations would also be appropriate). Another result would 
be to require the acquiring corporation to take a cost basis in all 
those assets, be it a "stepped-up" or "stepped-down" basis. A third 
result would be to prevent the acquiring group from succeeding to 
any tax attributes (e.g., net operating loss carryovers) of the ac- 
quired company. 

Present law, which provides the parties with an election to 
achieve the results indicated, may be viewed as unduly generous. 
However, changing the rules in the manner proposed would tend to 
reduce the price at which shareholders of some acquired corpora- 
tions could sell their stock and might inhibit the consummation of 
what would have been an efficient acquisition. 

H.R. 1003 (Mr. Jones) and S. 632 (Sen. Chafee) would both re- 
quire a target corporation to recognize all gain as though it had 
disposed of all its assets in the normal course of its business. The 
rule would apply in the case of a qualified stock purchase (as de- 
fined under present law section 338), but only if the acquisition was 
a "hostile" acquisition. 

Effect of election to treat a stock acquisition as an asset acquisition 

Alternatively, the law could be changed to modify the Federal 
income tax consequences of electing under present law to treat a 



qualifying stock acquisition as an asset acquisition (with appropri- 
ate conforming changes). For example, one consequence of such an 
election could be full recognition of all gain (or loss) with respect to 
the acquired company's assets. Present law permits the acquirer to 
step up to fair market value the basis of all the assets of the ac- 
quired company but does not require the acquired company to rec- 
ognize as taxable income any appreciation in the value of its assets 
(except for recapture items). This result is inconsistent with a pure 
two-tier tax system and differs from what would have happened 
had the acquired company not been acquired. 

More narrowly, the recapture rules applicable under present law 
in the case of an election could be tightened. For example, the ac- 
quired company could be required to recognize all gain or loss on 
property which if sold by it outside of an acquisition context would 
have generated ordinary income or loss (e.g., all inventory, includ- 
ing FIFO inventory). Gain on all section 1250 property (certain real 
property) could be required to be included in income, as ordinary 
income or capital gain, to the extent of prior depreciation deduc- 
tions allowed. This would tend to conform the section 1250 rules 
with those of section 1245 (relating to personal property and cer- 
tain real property). Gain on all mineral property could be required 
to be included in income to the extent of prior intangible drilling 
costs with respect to such property which were deducted, regardless 
of whether they were deducted before or after January 1, 1976, or 
whether the deductions exceeded what could have been recovered 
through depletion deductions had they been capitalized. Finally, 
gain on all mineral property could be required to be included in 
income to the extent of prior depletion deductions allowed, or, al- 
ternatively, to the extent percentage depletion deductions allowed 
with respect to such property exceeded those that would have been 
allowed under cost depletion. 

It has been argued that there is little justification for permitting 
an acquired corporation to avoid being taxed on the value of its or- 
dinary income assets in excess of their basis. As for tightening the 
recapture rules, the acquired corporation, in claiming depreciation 
and depletion, became entitled to tax benefits. Appropriate recap- 
ture rules, it is argued, would do nothing more than require an ac- 
quired company to return those tax benefits to the Federal govern- 
ment at the appropriate occasion. 

In 1983, the staff of the Senate Finance Committee published a 
report entitled ''The Reform and Simplification of the Income Tax- 
ation of Corporations".'* 2 The report contains numerous proposals 
to revise the treatment of shareholders and corporations. Perhaps 
its most significant proposal with respect to acquisitions would be a 
proposal requiring the recognition of all gain by a target corpora- 
tion on liquidating sales and liquidating distributions and other 
taxable acquisitions of a target's stock or assets. The deterrent 
effect that such treatment might otherwise have on acquisitions 
would be ameliorated to some extent by permitting acquiring cor- 
porations to elect to preserve the target's basis for its assets and 
tax history without recognition of gain (i.e., tax-free treatment), re- 

42 S. Prt. 98-95, 98th Cong., 1st Sess., (September 22, 1983). 


gardless of the nature of the consideration furnished by the ac- 
quirer. Furthermore, under the proposal, some reUef might be pro- 
vided to shareholders of the acquired company to adjust for tax li- 
abilities of the acquired company that the basic proposal would 

Both H.R. 1003 and S. 632 would, as indicated, treat the acquired 
corporation in a hostile stock acquisition transaction as engaging in 
a fully-taxable transaction, i.e., without any section 337 relief. 
Moreover, S. 632 would not permit the acquirer to treat as part of 
its purchase price (or as part of the basis of the assets deemed ac- 
quired) tax liability of the acquired corporation attributable to the 
deemed sale. 

Net operating loss carryovers 

It appears to be the case that net operating loss carryovers of 
either the acquired or the acquiring corporation play an important 
role in some mergers and acquisitions. In considering what 
changes, technical or otherwise, should be made to present-law sec- 
tion 382, Congress may wish to consider whether the current rules 
are too generous. 

Interest expense 

Because interest is deductible and dividends are not, present 
Code rules clearly provide a strong tax incentive for corporations to 
finance themselves with substantial debt capital. While the impact 
of the rules is certainly not limited to the acquisition context, the 
income tax law frequently motivates acquisitions by permitting 
taxpayers to deduct currently interest paid or accrued on debt (in- 
cluding installment debt) incurred in connection with an acquisi- 
tion. Many acquirers (and acquired companies) are in a position to 
use those interest deductions to offset income that would otherwise 
be taxable at a rate at or near 46 percent. (Meanwhile, the lender 
(which may be a foreign person, a tax-exempt entity, an insurance 
company, or a domestic financial institution) may not be taxable at 
a 46 percent rate, or at all, on the interest income.) 

While from a tax standpoint many corporations would be well- 
advised to leverage their capital structures to the maximum extent 
possible, there are non-tax reasons to resist that pressure. Chief 
among them, perhaps, is the general notion that the higher a cor- 
poration's debt-equity ratio is, the more precarious will its long- 
term financial position be. This, for example, if the company's for- 
tunes take a downturn, it may be unable to generate sufficient 
cash to enable it to service its debts. If so, its lenders may be forced 
to foreclose on the debt, with unpredictable results for the compa- 
ny, its employees, its customers, and the communities in which it 
has a significant presence. Thus, a corporation which increases its 
debt-to-equity ratio to fend off an unfriendly takeover attempt may 
be jeopardizing the future of those interested in its well-being. 

A possibility for change would be to disallow deductions with re- 
spect to interest paid or accrued on debt (including installment 
debt) incurred in connection with the acquisition of a company. A 
similar possibility would be to disallow deductions for interest paid 
or accrued in connection with a hostile stock acquisition. H.R. 1003 
and S. 632 would do this (although the rule of H.R. 1003 would not 


apply if the purchaser is a corporation). Such a rule, if it could be 
implemented properly, would take pressure off companies that did 
not want to be acquired but were unwilling to significantly in- 
crease their debt burden. Alternatively, the deduction may be disal- 
lowed only for interest paid or incurred on "junk" bonds. (See H.R. 
1100 (Mr. Jones).) "Junk" bonds, as defined in that bill, are debt 
obligations which, under general Code rules, look very much like 
equity and perhaps should be treated by the issuer as equity. The 
junk bond proposals should be compared to present-law section 279. 
That section also disallows the deduction of interest on certain 
kinds of nominal debt instruments which have significant equity 

The recent Treasury Department proposal (November 1984) 
would allow a corporation to deduct 50 percent of the dividends it 
pays. Such a rule would reduce the potential double tax burden on 
corporate earnings to a tax of not more than 150 percent of such 
earnings. The extent to which this rule would affect acquisition ac- 
tivity is conjectural, but, to the extent the relative tax cost of oper- 
ation in corporate form was lessened, any undervaluation of corpo- 
rate assets reflected in the market price of stock which is attributa- 
ble to double taxation may be reduced. Furthermore, the Treasury 
proposal would also have the salutary effect of reducing the tax in- 
centives for capitalizing a corporation with debt rath )r than equity. 
Similar results might follow from the Treasury's proposal to index 
interest expense and income. 

On a related but different point, another possibility for change 
would be to correct the rules to require, in appropriate cases, that 
interest paid or accrued by a member of a consolidated return 
group on debt incurred in connection with an acquisition (or any 
other debt) be allocated between domestic and foreign sources on a 
group basis. This rule might prevent an acquiring corporation from 
being able to allocate interest expenses away from foreign sources 
merely because the acquiring corporation uses subsidiaries rather 
than divisions to conduct business abroad. The Treasury proposal 
advocates such a rule. 

Installment sales 

Under present law, the acquiring corporation can use install- 
ment obligations to make an acquisition. Under the installment 
sale rules, the sellers frequently defer recognition of gain, recogniz- 
ing it only as principal payments on the installment obligations are 
received. On the other hand, the acquiring corporation gets a new 
basis in the acquired property equal to the total amount of princi- 
pal payments to be made over time. Particularly if the transaction 
is an asset purchase (or a stock purchased which the acquiring cor- 
poration elects to treat as an acquisition of assets), that basis may 
produce short-term tax deductions for the acquiring corporation. 

This mismatching of gain and deduction, which may be offset to 
some extent by recapture, might be corrected. One possibility 
would be to give the acquiring corporation the benefits of a new 
tax basis only if and as principal payments on the installment obli- 
gations are made. 

Another possibility would be to require the holder of an install- 
ment obligation to pay interest on the "interest-free loan" from the 


government contemplated by present-law section 453. In addition, 
the law might be amended to provide that deferral of gain recogni- 
tion would cease when its holder borrows against it. The recent 
Treasury Department proposals support that last suggestion. 

ESOPs and overfunded pension plans 

The role of ESOPs and overfunded pension plans in the merger 
and acquisition context could be studied and changed where and as 


The 1984 Act imposed significant tax burdens on parties to cer- 
tain golden parachute contracts and similar arrangements. H.R. 
1100 would impose an excise tax of 50 percent on all "greenmail" 
profits, as defined by the bill. Under S. 632 (Senator Chafee), it 
would be made clear that no deduction would be allowed for green- 
mail payments. 


The Appendix suggests some additional technical changes in the 
merger and acquisition rules, and related rules, which Congress 
might consider. 



1. Return-of-capital distributions 

Present Law 

In general, the amount of a distribution by a corporation to a 
shareholder is includible in the shareholder's gross income as a div- 
idend (taxable at ordinary income rates) to the extent the distribu- 
tion is made out of the corporation's earnings and profits. If the 
distribution exceeds the corporation's earnings and profits, the bal- 
ance is applied against and reduces the basis of the shareholder's 
stock. To the extent the distribution exceeds the basis of the stock, 
the excess is treated as gain from the sale or exchange of property. 

Possible Change 

In the case of a distribution that exceeds the distributing corpo- 
ration's earnings and profits, consideration could be given to treat- 
ing the distribution as a proportionate sale of the underlying stock. 

2. Pre-acquisition dividend strips 

Present Law 

A corporate shareholder is generally permitted to deduct 85 per- 
cent of the amount of dividends received from domestic corpora- 
tions. Because the maximum rate of tax on income received by a 
corporation is 46 percent, the maximum tax on dividends received 
by a corporation is only 6.9 percent. Thus, corporate shareholders 
of an acquired corporation have an incentive to realize the corpora- 
tion's earnings in the form of dividends rather than as capital gain 
on a sale of stock. Toward this end, preparatory to an acquisition, 
corporate shareholders may in some cases attempt to cause the ac- 
quired corporation to distribute earnings that are taxable as divi- 
dends, resulting in a reduction in the sale price of the stock and 
hence in capital gain. Compare Waterman Steamship Corporation 
V. Commissioner, 430 F.2d 1185 (9th Cir. 1970), cert, denied, 401 
U.S. 939 (1971) (a susidiary's distribution of a short-term note, 
which was paid off by the acquiring corporation after it obtained 
control, was recharacterized as a payment for stock in the subsidi- 
ary), with TSN Liquidating Corporation v. United States, 624 F.2d 
1328 (5th Cir. 1980) (where the corporate shareholder of the ac- 
quired corporation succeeded in establishing that a pre-acquisition 
dividend was not disguised consideration for a sale of stock). See 
also Rev. Rul. 75-493, 1975-2 C.B. 



Possible Proposal 

Dividend distributions to corporate shareholders before a stock 
sale could in precribed cases be treated as additional sales price. 

3. Redemptions through use of related corporations 

Present Law 

Section 304 was designed to prevent shareholders from drawing 
off a corporation's accumulated earnings and profits at capital gain 
rates through the device of having a related corporation purchase 
stock held by the controlling shareholders. The application of sec- 
tion 304 to noncorporate shareholders could result in the treatment 
of what would be long-term capital gain (taxable at a maximum 
rate of 20 percent) as dividend income (taxable at a maximum rate 
of 50 percent). In contrast, corporate shareholders benefit from the 
transmutation of long-term capital gain (generally taxed at a maxi- 
mum rate of 28 percent) into tax-favored dividend income (general- 
ly taxed at a maximum rate of 6.9 percent). 

Possible Change 

Consideration could be given to making section 304 inapplicable 
to the transfer of stock by corporate shareholders. The tax results 
under section 304 could also be more closely conformed to those 
under section 368(a)(1)(D). 

4. Section 351 

Present Law 

Section 351 provides nonrecognition treatment if one or more 
shareholders transfer appreciated property to a corporation in ex- 
change for stock in such corporation, and, immediately after the 
exchange, such persons are in control of the corporation. In one 
widely-publicized transaction, the minority shareholder of an ac- 
quired corporation obtained tax-free treatment under section 351 
on the receipt of stock, in the context of a larger acquisitive trans- 
action in which the acquiring corporation obtained a cost basis for 
the controlling stock interest in the acquired corporation (setting 
the stage for a liquidation that could have stepped up the basis of 
the acquired corporation's assets under the predecessor of section 
338). The Internal Revenue Service ruled publicly that a purported 
section 351 exchange that is an integral part of a larger acquisitive 
transactive must satisfy the continuity of interest doctrine (see 
Rev. Rul. 80-284, 1980-2 C.B. 117). This ruling was revoked in 1984 
(see Rev. Rul. 84-71, 1984-1 C.B. 106). 

Possible Change 

It may be advisable to provide statutory authority for the inte- 
gration of a section 351 exchange and a related taxable purchase of 
an acquired corporation's stock. Changes to harmonize the tax re- 
sults in section 351 transactions and tax-free reorganizations may 
also be appropriate. 


5. Dividend-within-gain limitation in boot dividends 

Present Law 

The amount of dividend income recognized by an exchanging 
shareholder on the receipt of nonqualifying consideration in a reor- 
ganization cannot exceed the amount of gain. 

Possible Change 

Consideration could be given to repealing the rule that treats 
boot as a dividend only to the extent of gain. 

6. Treatment of exchanging security holders in reorganizations 

Present Law 

If a security holder exchanges debt instruments in a reorganiza- 
tion, the new debt instruments are treated as qualified consider- 
ation unless the principal amount of securities received exceeds the 
principal amount of the securities surrendered. Given time value 
issues, basing tax, consequences on "principal amount" is distor- 

Possible Change 

The amount of nonqualifying consideration received by an ex- 
changing security holder could be measured by the difference be- 
tween the adjusted basis of securities surrendered and the issue 
price of securities received. 

7. Coordination of sections 357 and 361; amendment of sections 

311 and 337 

Present Law 

In general, no gain is recognized by an acquired corporation 
whose liabilities are assumed by an acquiring corporation in con- 
nection with a tax-free reorganization. Nevertheless, if the ac- 
quired corporation uses consideration received from the acquiring 
corporation to pay off its liabilities, the acquired corporation may 
be treated as realizing taxable gain. See generally Minnesota Tea 
Company v. Helvering, 302 U.S. 609 (1938) (under which an ac- 
quired corporation's distribution of boot to a creditor was not treat- 
ed as a distribution "in pursuance of the plan of reorganization" 
for purposes of the nonrecognition rules of section 361(b); and FEC 
Liquidating Corporation v. United States, 548 F.2d 924 (Ct. CI. 1977) 
(the application of which would also deny nonrecognition treatment 
under section 337 on a "deemed sale" of stock to a creditor). But 
see General Housewares Corporation v. United States, 615 F.2d 1056 
(5th Cir. 1980) (holding that section 337 can apply where the ac- 
quired corporation sold part of the stock received as consideration 
for its assets in a C reorganization and used the sale proceeds to 
pay debts). 


Possible Change 

Subject to existing restrictions in section 357 (b) and (c), section 
361 could be amended to prevent the recognition of gain by an ac- 
quired corporation that uses consideration received in a tax-free re- 
organization to pay off debts but otherwise to tax it on sales of 
assets (or the distribution of property not transferred to the ac- 
quirer) in the context of a reorganization. 

8. Depreciation recapture is certain tax-free exchanges 

Present Law 

Under present law, a taxpayer can effectively assign ordinary re- 
capture income to another taxpayer by transferring depreciable 
property in a tax-free exchange. For example, section 1245(b) pro- 
vides an exception to the recapture rule for depreciable personal 
property where the property is transferred in a section 351 ex- 
change. Similarly, an acquired corporation recognizes no recapture 
income if it transfers depreciable assets in a C or A regorganiza- 
tion. If depreciable property is transferred to a corporation that 
has net operating losses, for example, no tax may be imposed on 
the recapture income. 

Possible Change 

Consideration could be given to applying the recapture rules gen- 
erally when an asset is no longer accounted for on the return that 
benefitted from the previously-claimed deductions. Thus, there gen- 
erally would be recapture in all otherwise tax-free acquisitive reor- 
ganizations as well as when a subsidiary is no longer included in 
the consolidated return of the affiliated group that claimed the de- 
duction. In a section 351 exchange, the shareholder's stock might 
be tainted so that ordinary income would result on disposition of 
the stock to the extent of recapture income at the time of the sec- 
tion 351 transfer (with a corresponding basis adjustment to the cor- 
poration when the shareholder is taxed). 

9. Acquisition of small enterprises by large publicly-held corpora- 


Present Law 

Under present law, the exchange of stock in a small enterprise 
for marketable stock in a publicly-held corporation can qualify for 
tax-free treatment, even though the effect of the exchange resem- 
bles a liquidation of the shareholder's interest in the old corpora- 
tion. Furthermore, some reorganization forms permit the use of 
nonvoting stock or preferred stock. 

Possible Change 

Consideration could be given to denying reorganization treat- 
ment to any transaction in which less than 20 percent of the out- 
standing stock of the acquiring corporation is received by the ac- 
quired corporation's shareholders (i.e., a transaction where the ac- 
quiring corporation is more than four times larger than the ac- 


quired corporation). Such a transaction would be taxed at the cor- 
porate and the shareholder level. Furthermore, the use of voting 
common stock could be required in all reorganization forms. 

10. Conversion of a C corporation to an S corporation 

Present Law 

In general, an S corporation is not subject to tax but is treated as 
a conduit, similar to the treatment of partnerships. Thus, share- 
holders who elect to treat their existing closely-held corporation as 
an S corporation effect a material change in the tax character of 
their investment. Nevertheless, the conversion of a C corporation 
to an S corporation is not a taxable event. 

Possible Change 

An election to convert C corporations to S corporations, or cer- 
tain acquisitions by S corporations of C corporations, could be 
treated as taxable events, at least with respect to recapture 

11. Use of shell corporations to convert short-term capital gain 
into long-term capital gain 

Present Law 

In general, gain on the sale of stock that is a capital asset held 
for more than 6 months is taxed as long-term capital gain, at rates 
that are more favorable than those applicable to short-term capital 
gain. If an acquiring corporation or an investor purchases and sells 
stock of another corporation through a holding company the stock 
of which has been held for more than 6 months, it may recognize 
long-term capital gain, even if the holding company's only signifi- 
cant asset is that stock and even if that stock has not been held for 
the period required for long-term capital gain treatment. 

Possible Change 

Consideration could be given to looking through a corporation 
whose stock is sold for purposes of determining whether the appli- 
cable holding period is satisfied. This rule could apply to closely- 
held corporations substantially all of whose assets (excluding cash 
and marketable securities) consist of recently-acquired property.